Back to the Future?
The Evolution of the North American Natural Gas Market
Lori Smith Schell, Ph.D., ERP
Presented at the 4th ELAEE Conference, Montevideo, Uruguay: 8 April 2013
This paper discusses the impact of the “shale gas revolution” on the North American natural gas market. Although the author recognizes that there are many different natural gas market hubs located throughout North America, all of the pricing discussed in this paper is tied to the Henry Hub, located onshore Louisiana and the pricing point for the New York Mercantile Exchange (“NYMEX”) natural gas futures contract. Arbitrage potential requires that pricing at all natural gas market hubs throughout the extensive North American natural gas pipeline system rationalize with respect to pricing at the Henry Hub, making the Henry Hub price a good proxy as “the” North American market price.
NATURAL GAS MARKET DYNAMICS: THE SUPPLY SIDE
Although shale gas plays have been identified in many places around the globe, their development to-date has largely been in North America, and specifically in the United States. See Figure 1. Even in the United States, the significance of the shale gas revolution was only beginning to be gleaned as late as 2008. Using the U.S. Energy Information Administration’s Annual Energy Outlook (“AEO”) as a barometer of how our knowledge of the magnitude of this important resource was revolutionized in short order, it is noteworthy that the AEO’s only mention of “gas shale” is as one of several components of unconventional gas production through 2008. It is not until the 2009 AEO that growing expectations for shale gas in the United States (“U.S.”) merit a separate discussion and that “gas shale” gets a separate line item under the category of unconventional gas production. By 2010, the AEO presents a much more significant discussion about shale gas that includes a graph showing shale gas production back to 2008 and that forecasts its significant future growth. By 2011, shale gas production had begun to dominate the U.S. natural gas supply mix, and it is expected to continue to do so for the foreseeable future. See Figure 2.
Figure 1. Global Shale Gas Resources
Source: World Shale Gas Resources: An Initial Assessment of 14 Regions Outside the United States, April 2011, p. 3,
Figure 2. U.S. Dry Natural Gas Production by Type
The location of U.S. shale gas plays is playing as important a role as the magnitude of shale gas production. The geographic distribution of shale gas plays across the U.S. shown in Figure 3 has resulted in significant changes in natural gas pipeline flows and the resultant cost of transportation differentials between different market hubs. The Marcellus shale gas play in central Appalachia is located close to the major population centers in the Northeastern U.S. These population centers have traditionally been served by the long-line pipelines coming up from the U.S. Gulf Coast. However, the natural gas flows out of the Marcellus have reduced the need for those longer haul flows, resulting in pipeline companies reversing natural flows in some cases or converting some former natural gas pipelines into liquids pipelines. The required rationalization of natural gas prices between all interconnected North American market hubs means that the increases in shale gas production in, for instance, the Marcellus are affecting transportation differentials all the way back to California and Alberta.
Figure 3. Geographic Distribution of Shale Gas Plays in the Lower 48 States
NATURAL GAS FUTURES PRICES: RECENT HISTORY
As it turns out, the timing of the initial rapid growth of U.S. shale gas production corresponded almost exactly with the demand destruction that accompanied the Great Recession, though as described above, the increasing role of shale gas was not fully appreciated at the time. The combination of higher supply and lower demand led to a dramatic decline in NYMEX natural gas futures contract prices. Figure 4 illustrates the evolution of natural gas futures prices on the NYMEX in quarterly snapshots since the beginning of 2001. The 4/1/2008, 7/1/2008, and 10/1/2008 futures price curves are among the highest price curves shown and clearly illustrate the relative symmetry of the mid-summer 2008 natural gas price run-up. That is, natural gas futures prices on the NYMEX plummeted at about the same rate as they had increased. The 7/2/2012 forward curve is the lowest futures price curve shown in Figure 4 and reflects the combined impact of increased shale gas production and historically high natural gas storage levels that resulted from the very warm 2011/12 winter across the U.S.
Figure 4. NYMEX Natural Gas Futures Contract Pricing Evolution (January 2001-January 2013)
The plummeting natural gas prices in late 2008 were followed in short order by a sharp decline in the number of drilling rigs targeting natural gas, regardless of the type of drilling being done (e.g., vertical, horizontal, or directional). See Figure 5. Drilling rigs carrying out the horizontal drilling associated with shale gas plays recovered quite quickly, but decline again in early 2012 as natural gas prices headed lower. As drilling for natural gas declined, natural gas production leveled off after several years of significant increases. See Figure 6. This leveling off of production levels and increasing demand in response to low natural gas price levels combined to lead to rising natural gas prices starting in mid-April 2012, as seen in Figure 7.
Figure 5. U.S. Weekly Natural Gas Rig Count and Average Spot Price at Henry Hub
Source of Data: U.S. Energy Information Administration
Figure 6. U.S. Monthly Dry Natural Gas Production
Figure 7. 2012-13 NYMEX Natural Gas Futures Contract Monthly Settlement Prices
Figure 7 also clearly shows the dynamic price response as the very high natural gas storage levels during and following the winter of 2011/12 gave way to more normal storage levels throughout the winter of 2012/13, lending further support to natural gas price strengthening.
NATURAL GAS FUTURES PRICES: HISTORICAL PERSPECTIVE
It is informative to take a longer view of NYMEX natural gas prices to put more recent price dynamics into context. Figure 8 shows the evolution of the NYMEX natural gas futures contract monthly settlement price since the inception of the contract in June 1990, with gray areas indicating periods of economic recession. The role of natural gas storage levels, winter weather, and oil prices can be clearly seen, although oil prices have had a weaker impact on North American natural gas prices since the shale gas revolution has made itself evident.
Figure 8. 1990-2013 NYMEX Natural Gas Futures Contract Monthly Settlement Prices
Horizontal drilling and hydraulic fracturing (“fracking”) are not new technologies; both have been under development for decades. It was the confluence of the two that really catalyzed the shale gas revolution. The shale gas revolution in my mind is all about what is happening underground. Above ground, the markets are simply responding to changing supply and demand conditions. The evolution of settlement prices for the NYMEX natural gas prompt futures contract shown above in Figure 8 suggests that there is nothing new under the sun. What goes around comes around.
NATURAL GAS MARKET DYNAMICS: THE SUPPLY SIDE
To this point, the focus of this paper has been on the supply side. Given that prices are set through the interaction of both supply and demand, I will turn now to the demand side of the natural gas pricing equation. There has been an enormous demand response throughout the U.S. to the low natural gas prices that have occurred throughout the past several years, particularly given the outlook for continued strong shale gas supply going forward. Even the recent run-up that has taken natural gas prices to over $4.00 per million British thermal units (“MMBtu”) leaves natural gas prices at relatively attractive levels compared to the past decade.
ELECTRICITY GENERATION: BATTLE OF THE TITANS
The increased use of natural gas to generate electricity has received a lot of attention in light of the cost of retrofitting coal plants to meet tighter environmental regulations and the need for more flexible generators to meet the demands placed on the electric grid from increased levels of intermittent renewable generation. Coal-fired electricity generation has dominated the U.S. electricity supply picture for decades, though the fuel mix for electricity generation has notable regional differences. The extremely low natural gas prices that occurred in the spring of 2012 combined with slowly increasing coal prices yielded a hither-to unknown outcome in April 2012: The amount of electricity generated in the U.S. from natural gas equaled the amount of electricity generated from coal. Although this outcome was short-lived, it was noteworthy because of its unprecedented nature. Figure 9 shows the interplay and competition between natural gas and coal for U.S. electricity generation over the past six years, with the price of each commodity included to emphasize the price-quantity relationship.
Figure 9. U.S. Monthly Net Electricity Generation, Coal v. Natural Gas (With Prices)
However, electricity markets are only one commodity that has thrived on the relatively low natural gas prices resulting from the shale gas revolution. Other markets benefitting include chemicals and fertilizer production, transportation (e.g., compressed natural gas vehicles, fuel cell vehicles using hydrogen derived from natural gas, and electric vehicles), industrial production (e.g., steelmaking, glass), and manufacturing.
NATURAL GAS AND MANUFACTURING
Chemicals and fertilizer production have been major beneficiaries of the fact that much shale gas is rich in natural gas liquids (“NGLs”) such as ethane, butane, and propane. These NGLs must be removed prior to injecting shale gas into the interstate natural gas pipeline system in order to meet pipeline specifications. Pipeline specifications are typically stated as a range of values, which provides pipeline shippers some flexibility as to how much of the higher-carbon, higher-energy NGLs must be removed. The actual quantity of NGLs removed depends on the relative price of natural gas compared to the price of the NGLs. Shippers will opt to remove that level of NGLs that maximizes their total revenue while also complying with the pipeline specifications.
The sheer volume of ethane removed from the natural gas stream (a process referred to as ethane rejection) has put downward pressure on ethane prices, which has increased the competitiveness of the U.S. chemicals manufacturing sector. This in turn is leading to the return to the U.S. of fertilizer and ammonia manufacturing, methanol production, etc. Much of this manufacturing had moved offshore, in part in response to higher natural gas prices. Ethane is the primary input to ethylene production and ethylene is a major component of most of the everyday products that we consume, including carpet backing, insulation, trash bags, food packaging, diapers, tires, paint, adhesives, and sealants. Thus, the impact of lower natural gas prices and lower ethane prices permeates throughout the whole U.S. economy, impacting the production costs of many products and thereby directly increasing U.S. manufacturing competitiveness.
U.S. manufacturing competitiveness is enhanced due to the fact that chemical feedstock prices are tied to different commodities in different parts of the globe. For instance, in the U.S., ethane prices are tied to the price of natural gas, whereas in Asia ethane prices tend to be tied to the price of naptha, an oil product. This disparity in how ethane is priced leads to related disparities in the price of ethane in different parts of the world. Consequently, the ratio of the crude oil price to the natural gas price plays a critical role in determining the relative competitiveness of chemicals manufacturing in different countries. For U.S. chemical manufacturing to be competitive the oil-to-natural gas ratio must remain above 7; below this level, chemicals manufacturing will tend to move offshore as it did in the 1990s and 2000s. The historical evolution of the oil-to-natural gas ratio over the past 40 years can be seen in Figure 10, with the highs reflecting periods of greater U.S. competitiveness in chemicals manufacturing and the lows reflecting periods when chemicals manufacturing tended to move offshore.
Figure 10. Historical and Forecast Oil-to-Natural Gas Price Ratio
Source: American Chemistry Council, March 2012, “Shale Gas and New Petrochemicals Investment:
Benefits for the Economy, Jobs, and US Manufacturing”, p. 15f.
LIQUEFIED NATURAL GAS
Similarly, prices for liquefied natural gas (“LNG”) are also tied to different indices in different regions around the globe, resulting in widely differing natural gas prices by region. These differences are evident in Figure 11, which compares spot natural gas prices in the U.S. and the United Kingdom with the delivered price of LNG in Japan over a five-year period. These price differences create an economic opportunity for LNG exporters, but it remains to be seen whether it will be the LNG exporters or the LNG importers who capture the price difference between less expensive onshore natural gas supplies and more expensive delivered LNG. The outcome will depend in part on the negotiating strength of each side and will play a major role in determining the long-term interest of the U.S. natural gas industry in fostering new LNG export terminals.
Figure 11. Natural Gas Spot Prices at Major Global Markets
As previously stated, the impact of increased shale gas production in the U.S. did not really become apparent until the late 2000s. As recently as 2005, I presented a paper at the World Petroleum Congress in Johannesburg, South Africa, speculating on how many new LNG IMPORT terminals were likely to be built in the U.S. At the time, this was a hot topic and I was not the only one whose estimate was way off base, just another indication of how quickly the world can change as technological advances make their way into the market.
Be that as it may, there currently are nearly two dozen proposed or potential new LNG EXPORT terminals under consideration in North America. Many of these LNG export terminals are located at new “greenfield” sites but two of the four existing regasification terminals at “brownfield” sites in the U.S. have applications pending before the Federal Energy Regulatory Commission (“FERC”) to become liquefaction terminals (Lake Charles, Louisiana; Cove Point, Maryland) and another has been identified as a potential liquefaction terminal (Elba Island, Georgia). The question of the day is how many of these LNG EXPORT terminals will actually get built and in which locations, given competition from Canada and Mexico to be the first to market, assuming the price/profitably gap will close as new LNG supplies enter the global market. Twenty years ago the idea of a spot market for LNG would have been unthinkable; today it is commonplace for LNG tankers to be redirected from one market to another as market conditions and relative prices change. Given the uncertainty as to the timing and the location of new LNG supplies, the impact on global LNG trade flows is hard to determine.
NATURAL GAS AND RENEWABLES
Another factor that is perhaps unexpectedly increasing the role of natural gas is the fact that many states in the U.S. now have a Renewable Portfolio Standard (“RPS”). Figure 12 shows the RPS parameters on a state-by-state basis. Although some states have voluntary renewable portfolio goals, most RPS parameters are legislatively mandated. (While the U.S. has benefitted over time from relatively inexpensive and abundant supplies of energy, many renewable energy supporters do not realize that cheaper fossil fuel-based energy supplies actually work against the growth of renewables in the absence of an RPS.) Solar and wind are the major sources of renewable energy in the U.S. and both are to a lesser or greater extent intermittent in nature. As the penetration level of renewable energy increases on the electric grid, flexible generation that can rapidly adjust to fluctuations in renewable energy generation becomes increasingly critical to keeping the grid in balance. Natural gas generators are well suited to fill the need for flexible generation to balance the intermittency of renewables, though the need to continually ramp up and down means that such generators often operate at less than peak efficiency. Until technological advances make rapid-response, large-scale energy storage a viable proposition, natural gas will retain its place as the “bridge fuel” to a lower carbon grid.
Figure 12. State-by-State U.S. Renewable Portfolio Standards
Figure 13 illustrates the need for increased flexible generation as renewable energy penetration levels increase. This results presented in Figure 13 are from a recently completed three-year study funded by the California Energy Commission. The study was directed by the Advanced Power and Energy Program at the University of California-Irvine and I provided the economic and cost modeling as a complement to the technical and engineering modeling. Although specific to California in the details, these results can be generalized to other regions in terms of the increased need for flexible generation (i.e., load-following and peakers) as renewables penetration levels increase on the electric grid.
Figure 13. Need for Increased Flexible Generation Increases as Renewables Penetration Increases
Source: Eichman, J.D., et al., “Exploration of the Integration of Renewables Into California’s Electrical System Using the Holistic Grid Resource Integration and Deployment (HiGRID) Tool,” Energy (2012), http://dx.doi.org/10.1016/j.energy.2012.11.024
This paper has discussed only a few of the many factors that exert price pressure on natural gas prices, some to the up side and others to the down side. There any many competing factors the culmination of whose interactions are captured in the natural gas futures contract prices seen on the NYMEX. Factors of note that were not discussed in detail here include: The impact of investment lag in pipelines and processing plants as shale gas is brought into production in new areas; the impact on electricity demand of energy efficiency and demand response measures; the outlook for carbon pricing in the U.S.; the impact of tighter emissions controls on coal-fired electricity generation; the increased industrial demand for natural gas in steelmaking, glassmaking, and other energy-intensive industries; and, population growth and economic development at home and abroad.
Above ground, natural gas pricing really has gone “Back to the Future.” Despite the lower overall price level of the past several years, natural gas prices continue to be highly volatile. In many ways, there is nothing new under the sun above ground. Below ground is another story entirely.
4th Encuentro Latinoamericano de Economía de la Energía (ELAEE)Montevideo, Uruguay - 8-9 April 2013
ELAEE is the biennial conference sponsored by the Latin American Association for Energy Economics, an affiliate of the International Association for Energy Economics (IAEE). - A significant benefit of our USAEE/IAEE membership is the global networking opportunity afforded by conferences of affiliated organizations in which we are welcome to participate.
Volume 21 No 2 Announcements