GLOBAL RESOURCES: The Future of Natural Gas
February 2011
 atural gas is perhaps America’s greatest natural resource. It is abundant,
relatively easy to extract, requires less post-extraction processing than oil,
and is the cleanest of the fossil fuels (in both carbon and particulate emissions).
Additionally, these processes employ a lot of people. Despite these apparent
advantages, there has been no US policy explicitly designed to increase the use
of natural gas. Newly found deposits of gas and advances in drilling technology
have led to increased production of natural gas. Yet with no significant new
sources of demand and overall economic weakness as a result of the US recession,
prices for gas have collapsed. Gas effectively costs the same as it did at the
end of 2002, albeit with several major price spikes (most notably due to the Gulf
of Mexico hurricanes in 2005) and then subsequent declines.
It seems clear that the country should, and likely will, take affirmative
action to increase the use of natural gas over the next decade. Substantial
increases in demand are likely to take place only by a structural change in gas
applications, rather than simply by an increase in current usage. The most likely
scenario is to increase the use of natural gas as a source of electricity generation.
Economic improvement will also boost demand, but without a structural change
in energy policy, it is unlikely to shift the demand curve to the right. Investors are faced with difficult choices regarding how to best take advantage
of opportunities related to natural gas. Given its abundant supply, it is not
clear how great an impact increased demand will have on pricing. Furthermore,
natural gas futures have proven difficult to navigate successfully. As an alternative,
investments in natural gas companies should provide returns from the increased
use of natural gas, while at the same time addressing the price risk of natural gas.
Gas related companies, including servicers, drillers, pipeline operators and those
that build gas storage and transportation facilities, are likely to see an increase in
business (and profits) as the country shifts to natural gas power. Supply Considerations for Natural Gas. It is generally accepted that
the US has vast amounts of natural gas. However, for several reasons the exact
amount of gas is hard to determine. One issue is the classification standards mandated
by federal rules. To qualify as a “reserve” the gas has to be in the ground and
be viable for extraction both technologically and economically. The improvements
in drilling technology have resulted in consistent upward revisions to the estimates
of gas available for consumption. Fluctuations in the price of gas also result in
changes in what is determined to be “economically viable.” Consequently there is inconsistency in the different measures of reserves depending on the timing of the
evaluation. This creates the counterintuitive situation where increases in the price
of gas result in additions to reserves. Chart 1 below shows the nature of US natural
gas reserves by type. Note how fluid the concept of a reserve can be, changing with
price and drilling technology in addition to new discoveries.
The MIT Energy Initiative1 has used an estimate of 2,100 trillion cubic
feet as the US resource base. This represents 92 years of the natural gas supply at
today’s level of consumption. But this figure largely ignores gas reserves (including
frozen gas called methane hydrates) that are commercially nonviable given today’s
technology. Even if sources differ as to the size of US reserves, it is clear that they are sufficient to warrant not only further exploration but
infrastructure development that increases US consumption
of gas relative to other carbon based fuels.
Demand Considerations for Natural Gas. Natural
gas has many uses but can be divided approximately
into thirds: 1) electricity generation, 2) direct use (home
and commercial heating, hot water and cooking) and
3) industrial use (including the manufacture of chemicals,
plastics, agricultural operations and similar uses). Chart 2
provides greater detail on gas usage.
Over the short term, weather is the primary determinant
for natural gas demand. Historically, demand
for gas was highest in the winter and lowest in summer,
reflecting its use in home heating. The seasonal cyclicality
has been muted recently due to the increased use of gas for electricity generation in the summer. Even though
electricity is the dominant use for natural gas, only about
18% of all electricity is generated by gas, while almost 50%
comes from coal.
Two factors impact demand for gas in electricity
generation. The first is gas price relative to coal. Historically,
coal has been a cheaper source of electricity generation
than either gas or oil. However, given depressed
prices for gas and increased demand for coal (largely from
China), this historical relationship is being challenged.
Chart 3 shows the levels at which gas displaces coal.
The second factor involves environmental regulations.
Gas is by far the cleanest of any fossil fuel (see
Table 1) Of major potential importance is any change in
regulation on carbon dioxide (CO2). If the US enacts
a carbon tax, a “cap and trade” regime for CO2, or any
other concerted effort to reduce CO2, natural gas use
would likely increase significantly. Should other major coal producers enact similar rules (especially China, which gets
approximately 70% of its electricity from coal), coal prices
in the US would likely fall, reducing the use of gas2. The
precise impact is unknown, especially since the political
climate in Washington makes major environmental policy
changes unlikely. However, the environment is still a long
term consideration, as well as a transnational one.
Possible new uses for natural gas. Given
that the US has so much gas, the question is how best to
exploit it. In the absence of policy changes, demand for
natural gas would appear range bound. Weather impacts
create a great deal of volatility in demand, yet weather is
exogenous and unpredictable. Industrial demand for gas
is directly tied to the overall state of the economy, but the
underlying factors are well known (and modeled) once
the economy becomes more certain.
While natural gas is widely used for electricity, it
may be surprising that despite its apparent advantages as
a fuel source, the US does not generate more electricity
from natural gas. The reason is shocking given today’s
acknowledgement of the vast quantity of gas in the US.
In the late 1970s, geologists believed that the country
was running out of natural gas. In 1978, Congress passed
the Power Plant and Industrial Fuel Use Act. Though
repealed in 1987, for nine years the construction of additional
oil or natural gas burning power plants was illegal.
Combined with negative reactions to nuclear power post-Three Mile Island and pressure from coal states’ political
leaders, coal became entrenched as the country’s primary
source of electricity.
Second to electricity, transportation requires the
greatest amount of energy. This need is met almost
exclusively by oil. Natural gas as a transportation fuel currently
has limited applications, mostly for some buses in
select cities and in airports and other closed loop systems.
Natural gas is also used in the production of ethanol, a
small but growing source of transportation fuel. Over
70% of the petroleum consumed in the US is used as a
transportation fuel. Industrial applications represent the
balance. Home heating is a distant third for oil uses.
Although the concept of “energy” is widely discussed,
energy is not fungible. Quite to the contrary,
energy is highly segmented by both source and use. As a
result, we believe that only a conscious and likely publicly
led initiative will promote the increased use of natural
gas.
The most likely catalyst for using natural gas as a
transportation fuel is not direct application but by the
increased use of electricity as a transportation fuel in electric
cars. Modifications to the electricity grid will have to
be made to accommodate electric cars. Adding gas power
into the grid may become part of a coming national
infrastructure upgrade.
The Effect of Contango. The natural gas market
has unique features compared to other commodities. It
is highly seasonal, with an undulating futures curve that
peaks in mid-winter reflecting use for heating. In contrast,
the futures curve tends to be in one continuous arc.
The natural gas market also has had a recent
tendency to be steeply in contango, meaning contracts
for future delivery have higher prices than the current
spot price. This makes passive investing in natural gas
futures (or the ETFs that follow this strategy) poor investments.
Passive managers must settle contracts at expiration
at their current prices, but reinvest at higher prices
due to the shape of the curve. At times, this can cost 20%
in a year (in other words, the price of gas would have to
increase by 20% just for the investor to break even).
The recent steep and persistent contango in the
natural gas market has another, more subtle effect. The
steep contango encourages natural gas producers to
maintain an aggressive drilling schedule, far more aggressive
than one would expect simply by looking at current
spot prices. Why? Because natural gas producers often
hedge, selling most of their production for the coming
year at the (higher) forward prices. Producers often
hedge several years out. The amount of hedging varies by
producer, based on both the shape of the curve (steeper
contango encouraging more hedging) as well as their
predictions for prices in the future. Another consideration encouraging production of
natural gas despite relatively low prices is the prevalence
of Held to Production (HTP) contracts. These require
developers who lease land for drilling to actually attempt
to produce gas, or the lease will terminate. These contracts
also serve to encourage drilling that otherwise
might be postponed until spot prices rise.
So natural gas producers are encouraged to “buy
low” (by extracting gas today) and “sell high” buy selling
gas for delivery in the future. As long as this trade is
profitable, there will be downward pressure on prices as
supply swells awaiting future delivery. What happens to
all this gas? It ends up in storage. We see the impact of
this in the amount of gas in storage in both the US and
Canada (Chart 4). While down from record highs, gas in
storage is still near the theoretical capacity in the system
of approximately 4.3 trillion cubic feet.
Impact on Pricing. Combined, these factors
explain the long term behavior of the natural gas market.
Even though demand is increasing, and there is some reasonable
indication that this trend will continue, the price
of natural gas (in the absence of some severe weather
events) has been effectively stagnant. The key factor is the
same thing that makes it so attractive, its abundance. Not
only is natural gas plentiful, but relative to oil it is easy
to extract. The explosion of the Deepwater Horizon drill
rig and subsequent difficulty in capping the damaged
wellhead demonstrated the difficulties and expense of
drilling wells not only deep, but often miles under the
ocean floor. In contrast, there are significant unexploited
natural gas reservoirs available either onshore or in relatively
shallow water off the coast.
What to Do. How can one invest in a more
natural gas powered future without taking on explicit
price risk on gas itself and subjecting the portfolio to a
continued contango in the natural gas market? There
are several options.
- Natural Gas Companies – Natural gas companies
often hedge themselves. Some hedge more, either
by selling more production or extending the
time over which production is sold. Companies
with more robust hedge books, as well as those
that have demonstrated some success in hedging,
should have less sensitivity to current prices. In
addition, companies with large reserves relative to
current production also have reduced sensitivity
to short term price fluctuations, since the market
pays more attention to the value of reserves and
less on earnings generated by current production.
- Gas Focused Servicers and Drillers – Regardless
of the short term volatility of natural gas prices
and the technical nature of futures trading,
companies that extract gas from the ground need
drilling, pressure pumping, wellhead equipment
and related services. The revenue for companies
in this sector is not dependent on the price of
natural gas. Short term, these companies are correlated
to gas prices. But if the long term outlook
is correct and natural gas becomes more widely
used, the future for servicing and drilling companies
becomes very positive.
- Pipeline Companies and MLPs – Unlike oil, which
is easily shipped between ports and between countries,
gas is much more difficult and expensive
to transport. Transportation costs are significant
relative to the underlying price of gas. This is
evidenced by the substantial basis, or cost differential,
between gas at different locations, even within
the US. Gas pipeline companies, often structured
as Master Limited Partnerships, make money on
the movement of gas, not its price. As a result,
these companies should participate in the growth
of gas as a fuel even if prices remain low. In some
ways, these companies actually benefit from lower
prices, as they make gas more competitive than
other fuel sources, notably coal.
- Engineering and Construction Companies – A
more natural gas fired future requires significantly
more infrastructure for gas transportation, storage
and conversion to electricity. This is especially true
for those regions that currently have little gas production,
such as those above the Marcellus Shale
in eastern Pennsylvania and New York.
- Utilities – The ability of utility companies to
benefit from increased use of natural gas will
be dependent on regulatory bodies at both the
national level regarding carbon generation and
local level regarding rate setting.
Conclusion. From a public policy and macroeconomic
perspective, it appears logical that the US energy“portfolio” is likely to become more gas intensive in the
years and decades to come. Investors will reallocate their
portfolios to accommodate this change. However, the
primary beneficiary of increased gas demand may not
be gas exploration companies, but those companies
involved in the build-out of a natural gas powered
infrastructure. We present these ideas not as short term
opportunities, but as long term themes likely to influence
investor behavior for years, if not decades. |
