Friday, August 31, 2012

Wishful thinking on natural gas prices

Rod Adams of Atomic Insights has posted a string of arguments in the general thread that natural gas prices are set to explode - or at least, precipitously increase - and that further, the current historic lows in natural gas prices are a mirage, one carefully put into place by gas producers to squeeze out competition, particularly in the electricity sector. In his latest post, "Where is the huge increase in US natural gas supply?" Rod points to EIA data indicating that the "flood" of new natural gas is anything but.

There's just a small problem in this assertion - the data doesn't support Rod's claims. And I say this as someone who obviously would like this to be true. Low natural gas prices have largely put the brakes on new nuclear construction - the latest casualty being Exelon's planned Victoria unit in Texas. Obviously, Exelon has made its position known on whether it will be investing in new nuclear units in an environment where natural gas is currently cheap (it won't), so this comes as a surprise to no one. In fact, the overwhelming majority of new electric generation capacity in the U.S. over the last decade has been natural gas.

Rod makes the claim that the cause of currently low natural gas prices is less due to new supply and more due to slumping demand for energy given the recession. As evidence of this, he points to this chart from the EIA, indicating gross withdrawals of natural gas at U.S. wells.

Rod's argument is that the new supply hitting the market isn't exactly overwhelming - and therefore, when demand picks up, so will prices. The data Rod is using to justify this reasoning is withdrawals at the wellhead - which indicates how much supply is hitting the market. The trend is easier to see on the annual withdrawals basis.

While we don't see an "explosion" in terms of orders of magnitude difference, looking at the data, it's clear that natural gas withdrawals have increased by over 20% since 2005 - hardly insignificant.

But frankly, this is the wrong metric to look at the begin with. If we want to know the real story with natural gas supply, we need to look at proven reserves (i.e., the amount of natural gas we have reasonable certainty of economical recovery from the ground). Again, going to the EIA data, we see the same trend; since 2003, proven U.S. reserves have increased from about 7.5 billion barrels to 9.3 billion in 2011 - a 24% increase. Again, while not mind-blowing, this is not insignificant.

However, we're still missing one last piece of the puzzle - natural gas consumption. This of course is the key to Rod's argument - we've demonstrated that supply has increased, although perhaps not "exploded." But Rod claims that much of what has contributed to temporarily low gas prices has been slumping demand due to a down economy. We can easily evaluate this claim by looking at total consumption data.

On a month-by-month basis, peak consumption (in January) did decline from 2011 to 2012 - by about 5%. This may be partly due to a sluggish economy, but probably more so due to an anomalously warm winter. To get a better feel for total consumption trends however, one should look at the annualized data, "smoothing out" some of these peaks.

On an annual basis, natural gas consumption has been rising - since 2003, net consumption has increased by about 10%. Looking at just the last six years (from a minimum in 2006), gas consumption has grown at a maximum of about 14%.

So now to recap - natural gas supply, in terms of proven reserves, has increased by about 24%, while natural gas consumption has only grown by 14%. Basic economics allows one to predict what happens to price under this circumstance - supply has, in the short-term, outstripped demand. However, while demand has dropped off a little in 2012, supply has been outstripping demand for the last 10 years - this is not a temporary phenomenon.

Now, one can make the argument that eventually demand will catch up with supply - in which case, prices certainly will begin to creep back up. But there is no evidence that proven reserves themselves are declining, which means predictions of the imminent explosion of natural gas prices have, unfortunately for nuclear, little basis in reality.

This gets me back to a recurring point I make many, many times - for nuclear to be viable, reducing capital costs and eliminating the risk premium must be the absolute first priority. (A second, equally important priority would be in establishing a clear price signal on carbon dioxide - very much contrary to the giveaway to natural gas producers which the EPA's current target amounts to.

Expecting a deus ex machina spike in natural gas prices to save new nuclear construction simply isn't going to happen in the short-run. It may be true in the long-run - a decade or more away. And certainly any utility looking to hedge against future price volatility in fuels would be smart to invest in nuclear. But there isn't any evidence that a sudden increase in gas prices will come to nuclear's rescue in the near-term, and this is important - not because I don't want to see new nuclear get built, but because nuclear advocates need to be clear-eyed about the reality confronting them. Self-deluding arguments might feel good in the short-run, but they do little to see to it that new nuclear plants actually get built.

Update: In the spirit of Bryan Caplan of Econlog, Rod has made a wager ($50) with me; that there will be at least one month by end of 2014 in which natural gas prices at Henry Hub will exceed $10/MMBtu (Rod is betting that they will exceed this). I have to say, I respect anyone willing to put their money where their mouth is. I hope I'm wrong, but I doubt I will be.

For reference, here's the historical EIA data on natural gas prices. (For clarification: 1 MMBtu = 1000 Btu; 1000 cubic feet of natural gas contains about 1020 Btu, or 1.02 MMBtu)


  1. Hi Steve.

    Super post on "doing the numbers."

    But can we trust the numbers?

    I trust production numbers. I trust consumption numbers. I don't trust "proven reserve" numbers, because they can be manipulated to justify various things, such as borrowing money for drilling.

    One number you didn't look at was "active drilling rigs looking for gas." That number is at a multi-year low. On an earlier post of Rod's, I commented and quoted two Forbes articles saying that shale-gas is expensive to produce, and isn't worth drilling for unless you can get $6 MMBtu. Other Forbes articles encouraged investors to avoid natural gas-based stocks because they are "running through their capital and taking out lines of credit." (Or words to that effect...there should be links in my comment on Rod's earlier post. Or Google Natural Gas and Forbes.)

    In other words, with few rigs operating, I don't expect $10 gas, but I DO expect $5 or $6 gas (near the production cost) within about 3 years. When this current over-production is burnt off (literally).

    Why 3 years? Because shale wells don't tend to have a long production life, but there are a lot of shale wells out there right now, so my guess is...3 years. I am allowed to guess. Am I putting a wager down on this? If you want, I will. Not what I usually do.

    Wager: $10 says gas will be at $6 at the Henry Hub by the end of 2015. You want to take that one? Or do you agree with my position? Or...???

    1. @Meredith: Some very good points you bring up. I did neglect to look at new wells being drilled, and I suspect you are correct here - what we are seeing is basically an equilibrium being established. With the proliferation of hydraulic fracturing, everyone rushed to drill new wells, causing supplies to spike and prices to plummet. Suddenly, the price of gas is going for too low to recover the initial investment.

      If anything, I suspect you are correct that we will likely see an equilibrium develop around say $5-6; i.e., as prices stabilize and one can recover a net profit from new wells, the number will creep up again - slowly. That's kind of what I'm getting at in a roundabout way (and something I want to discuss about uranium prices in a future post); exploration tends to follow price. If the price collapses, so too will exploration; and vice versa. I suspect we agree on this point.

  2. Of course other parts of the world do not have access to cheap pipeline gas. This is why we see nuclear construction in South Korea and the UAE while the US remains stagnant.

    1. @Robert: Absolutely true; I glossed over this point, but natural gas is inherently a regional commodity, not a global one. The economics of nuclear are far different outside the U.S., especially in places which lack for abundant coal and/or natural gas resources.