Enerdynamics
Energy Insider

Natural Gas « Back to Energy Insider

Natural Gas: Fundamentals Continue to Rule Natural Gas Pricing

by Belinda Petty, Enerdynamics Instructor

 

Natural gas prices in North America rise and fall. In the last decade, the Henry Hub monthly price has been as high as $14/MMBtu and as low as $2/MMBtu. How can the same commodity at the exact same location be sold for seven times more one year than the next? Can we expect such instability to continue into the future, and should we be wary about becoming more dependent on natural gas as a key fuel?


Why price levels change
In North America, natural gas is a commodity whose price is driven by fundamentals. The value of natural gas, or price level, is determined by the perception of the supply and demand picture. Long supply, meaning suppliers are producing more supply than required by market demand, pushes prices down since buyers are able to negotiate price among multiple suppliers who need to sell for cashflow. Short supply means that production is equal to or less than demand. This results in buyers bidding up the price so they can get supply before another buyer does.


Currently in North America, the market perceives the balance to be supply long, and prices are at a traditionally low level below $4/MMBtu. Price volatility, or short-term price spikes and dips, is the result of a perceived supply and demand imbalance caused by supposed changes in underlying fundamentals. Once the fundamental factors causing the spike and dip resolve, prices should fall back in line with the overall perceived value of the commodity.


A century of natural gas use has led to the development of a robust set of assets to produce gas and move it to consumers, thus fulfilling the overall level of gas demand. These assets include a variety of supply basins with producing wells, gathering systems, processing plants, transmission pipelines, storage facilities, distribution networks, and a variety of customers. As long as there is excess capacity along the network of assets, there is flexibility to meet minor changes in the supply/demand balances. However, any major change in the balance disrupts the market, and the pricing, until the change can be absorbed.


This process may include getting new assets in place to alleviate the imbalance or customers changing their usage patterns. But in some cases, like the recent development of techniques to economically produce shale gas, major changes are structural and result in a long-term transformation of market fundamentals.


Market changes can come from anywhere along the value chain. Sometimes they impact the entire market. Other times they impact a region or location only. Let’s look at a few examples of game-changers in recent years on both the supply and demand side.


Rockies oversupply
During the early 2000s, a new era of gas supply growth developed in the Rockies. Producers began drilling coalbed methane. This new dry gas source was quick to drill and easy to standardize without the need for lots of new processing plants. While area and regional demand absorbed some of the new production, supply quickly outstripped demand by 2005. Rockies prices, which had been rising in concert with national natural gas prices, began to fall.


By 2007 Rockies prices had dropped by more than 30% to less than $5/MMBtu, and some spot prices fell dramatically to as low as $0.05/MMBtu. Rockies producers had to do something to change the market fundamentals or they were all going to be broke!


By the late 1990s some producers, knowing a fundamental supply and demand mismatch was coming, began to discuss a new pipeline to move Rockies gas east. In 2004, the Rockies Express Pipeline (REX) construction began. By the time the first phase of REX received gas in 2007, Rockies supply far outweighed the demand. Rockies prices still traded at a significant discount to the rest of the market.


When Phase II came on line in 2008, Rockies prices flew up in response to the additional markets now accessed by the new pipeline capacity. The additional markets shifted supply from the Rockies to the Midwest, pushing out more expensive Gulf Coast supply and eroding the overall national price level. When Phase III opened new markets to Rockies supply all the way to the Ohio/Pennsylvania border, Rockies prices began to move in unison with the rest of the gas market.


The graph below compares the growth in production with the impact on Rockies regional prices during REX commissioning. The market saw the imbalance coming, but the lead time to react took longer than the growth of supply. Building pipelines, storage, or distribution systems take long periods of time due to regulatory requirements and capital commitments. So there is often a timing mismatch between a major market change and getting the assets in place to absorb the change.

 

 

 

 


Increase in natural gas electric generation
Overall gas supply in the U.S. has grown dramatically for the last five years. The growth has come as success in drilling shale formations has boomed. Initially, the new shale volumes were concentrated in the southeastern parts of the U.S., specifically in Texas and Louisiana. New supplies caused downward overall pricing pressure but were absorbed into a robust network of pipelines and markets accessible to Gulf Coast supplies. However, as the Marcellus shale in Pennsylvania began its prolific rise in production, the supply and demand imbalance resulted in a fundamental shrinking basis between northeast prices and Henry Hub as well as Henry Hub gas prices falling from $4 to $2/MMBtu over the course of 2011.

 


 

 


But, as fundamentals change, markets adjust. Declining gas prices pushed natural gas into parity with coal as a fuel source for electric generation. Typically when gas prices drop below $5/MMBtu some inefficient coal units can no longer compete with gas generation, and as prices drop below $4/MMBtu fuel switching to gas becomes dramatic. As gas prices fell, electric generators accelerated the switch from coal to gas as the fuel of choice for generation. The new demand absorbed a huge supply overhang allowing prices to stabilize to today’s level.


Regional Marcellus supply basis shifts
Regardless of the overall supply balance position, regional factors can impact locational pricing in dramatic ways. This has been the case in the Marcellus shale basin at various points since 2011. The Leidy supply hub is the most recent example. New production has been building upstream of Leidy since 2009. In 2012, new production had grown to the point where no unused transmission capacity was available to move incremental gas to market. Producers began competing with each other to ensure their gas would flow.


Gas prices eroded to a one-day low of $.05/MMBtu. Market participants scrambled for ways to alleviate the bottleneck. From the first of 2013, new gathering, processing, and pipeline capacity has been built to allow the majority of production to move. With the last of a new 1Bcf/d tranche of transmission capacity commissioned on Nov. 1, 2013, Leidy pricing has shifted from a -$1.45 basis to Henry Hub to a -$.40 price basis to Henry Hub. The supply/demand balance has been restored with assets in place to move the majority of gas to market. Again, the time to get regulated assets in place took longer than the time needed to develop the production, gathering, and processing.


What does this say about the future?

Given the price instability we’ve discussed, is natural gas a reliably economical fuel source over the long term? Or is it too risky and are prices likely to rise soon? No one knows for sure. Variables include:


• new asset and capital commitment
• whether shale producers will continue to find and produce cheap supply
• whether environmental concerns will curtail shale production
• how quickly natural gas demand will grow
• and whether natural gas exports will become significant.


A recent modelling effort by Stanford University[1] suggests that under most scenarios it is likely that prices will stay below $6/MMBtu over the next decade. But keep your eye on the changing fundamentals — as history has shown a change in fundamentals can result in dramatic shifts in natural gas prices.

 


References:

 

[1] See Changing the Game? Emissions and Market Implications of New Natural Gas Supplies, EMF Report 26, Volume 1, September 2013, p. 23 (available at http://emf.stanford.edu/files/pubs/22532/Summary26.pdf)

 

 


Enerdynamics
Click here for more information or call 866-765-5432 Fan us on Facebook Follow us on Twitter

Enerdynamics Corporation • 3101 Kintzley Court, Unit F • Laporte, CO 80535 • (866) 765-5432 • info@enerdynamics.com

Legal: The Energy Insider and the content within include statements, opinions and analysis relating to energy industry topics of interest. The purpose of this newsletter is to apprise readers of industry trends and news. The information contained in this newsletter is provided as general information for educational purposes. Enerdynamics takes no responsibility for the accuracy of forward-looking statements or opinions of third-party sources.

Unsubscribe Forward