Sunday, February 12, 2012

The end of natural gas price volatility?

We hear it all the time - natural gas prices are volatile. Here are graphs for natural gas prices and crude oil prices over time that I uploaded to Wikipedia a while ago to illustrate this exact point.

Natural Gas

Crude Oil

But firstly, we need to make some distinctions. The matter of daily and monthly volatility is, indeed, different than the longer term volatility. I disadvantaged oil a little in the graphs above by giving a larger time frame. The take-away is pretty clear, the prices just behave differently. NG is much more "spikey". In other words, NG has more short-term volatility. There really isn't a clear case that long-term volatility is greater for either I think, but these are very different animals with oil being a much more global market.

Conoco Phillips recently put up a great video on youtube making the point that NG has been volatile in the past due to reasons mostly having little to do with the nature of production (instead, the nature of the use), and that the volatility will be less in the future given recent developments. Here is the video:

Because these are such important points that get to the core of the issue, I want to list them. I'm going to tackle the 2 arguments I mentioned above.

Why Natural Gas is Volatile in the first place:
  • It's a commodity and all commodities have price volatility
  • It is a margin fuel for power production (because it has the highest variable cost)
  • Once before, the long-term price of NG made a major move upward after much investment into NG power plants that left decision makers regretting that and leaving them skeptical of NG commitment in the future
Why it will be less volatile in the future:
  • We have more storage than in the past
  • We can bring in LNG (liquified natural gas, a way to import the commodity) to up to 25% of our demand
  • Shale gas is like a manufacturing process, and it's something you can ramp up very rapidly
  • The on-shore production is not subject to weather related disruptions, like hurricanes which have historically been the reasons for major disruptions
  • The abundance of resources and diversity of supply makes long-term price much more stable and confident
  • (non-reason) States could change the rules to not disadvantage hedging of NG price risk in their utility boards
The core argument is that utilities could rely on NG more if the rules would take down some of the barriers that prevent making hedging bets. I agree with most points here, but I agree with some of them less. My main beef doesn't have to do with the business structure of shale gas development, but more so what the current NG market is telling us, and what that implies for the future.

I was happy to see that The Oil Drum (TOD) was quick to comment on the current dip in NG prices, disproving everything they can about the future history of NG production. Most organizations don't share this view. As I've pointed out before, the EIA AEO 2012 paints a picture of continuously increasing NG production. NG is increasing in production second only to non-hydro renewable power sources. I prefer to agree with TOD and the EIA at the same time - believing that the main difference is the price set-point. The EIA projection, however, I think is a little dubious with their price assumption.
With increased production, average annual wellhead prices for natural gas remain below $5 per thousand cubic feet (2010 dollars) through 2023 in the AEO2012 Reference case.
This just doesn't make sense to me. I'll give you the price claim, but not the price claim at the same time as the increasing production claim. Those are mutually exclusive. But to get back to the point of the video - diversity of sources should offer a hedge to prevent the drastic volatility we've seen throughout the last decade. Equilibrium price and volatility are two very different things, and I have no reason to contest the flexibility (as opposed to the economics) of NG supply.

My claims
The market is going to have to figure out what it wants. I believe this is a fairly elastic market on both the production and consumption side. By all means, we should take realistic assumptions when considering the next infrastructure steps to take. Claiming that we need a low price NG market for our chemical industry global competitiveness doesn't make a lot of sense to me when presented at the same time as NG as an alternative to transportation fuels. Commuter vehicles can outbid the chemical industry most of the time.

There's a bit of a larger choice afoot. Nationally, we can embark on pro-export or pro-consumption policies. We can take the pain in a different place in order to make our industries more competitive. We just can't have everything all at the same time.

Other connections

This post was written after reading the THE CRANBERRY EFFECT: GAIN WITHOUT THE PAIN, on the RTI director's blog, which explains why I brought up several parts of the subject matter in the first place.

I should also mention what the NG environment today means for nuclear. Well, I tend to think that less price volatility (even from a competitor) isn't going to hurt anyone. The market for nuclear power depends on the need for bulk power. The better buffer that exists to smooth out the prices on shorter term scales, the easier nuclear, as well as renewables, can market themselves as bulk power providers, and by that I mean baseload and variable with respect to supply. More productive uses of NG in other industries would push utilities to add more nuclear as well as wind in order to displace more of the NG purchases and further specialize NG for peak times.

Also, another related perspective to read is Role of nuclear energy in creating smarter US grid networks.

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