The Lack of a Natural Gas Shock

February 12, 2015 § Leave a comment

This is a Guest Post by Daniel Kauffman

Everyone has noticed that the price of gasoline is down significantly in 2015, with average prices in the range of $2.00-$2.20 per gallon compared to $3.40-$3.70 per gallon last summer.  This 40% decrease makes sense given the 50% decrease in the price of a barrel of oil, which has dropped to $45-55 per barrel of West Texas Intermediate in 2015 compared to $95-$105 last summer.  What has largely been overlooked is that though our gasoline bill is way down, our natural gas bill is not.

Last summer I was paying $0.93 per therm (about one hundred cubic feet) for natural gas, and now I am paying $0.89 per therm, only 4% less.  How is it that we are seeing less money leave our pocket for gasoline but not for natural gas?  Is there no downward natural gas shock to mirror the recent downward oil shock?   Domestic wholesale natural gas prices have fallen, but not by as much as oil has.  Henry Hub wholesale natural gas spot prices saw one million Btu (MMBTU) of natural gas (about 10 therms) trade in the $4.00-$4.50 range last summer, and are now trading in the range of $2.60-$3.00 (note: a million Btu is about 10 therms, so that is a drop from ~$0.42 to ~$0.28 per therm).  The first thing to notice is that the wholesale natural gas price drop of ~1/3, though significant, is not as large as the 50% oil price drop.  The second thing to notice is that the price pass-through to the consumer is much higher for oil:  around 70-80% of the price decrease in oil is being passed through to the pump in its refined derivatives of gasoline and diesel, whereas we are only seeing a scant 4¢ cent/therm retail price cut on natural gas from a 10-15¢ cent/therm wholesale price drop, a less than 50% pass-through.  The natural gas I am using to heat my home seems to be more expensive than it ought to be.

Let’s take these two issues separately: first the smaller wholesale natural gas price decrease, then the smaller pass-through reduction.

Kauffman graphic

Two Years of Wholesale Oil and Natural Gas Prices

Source:  Bloomberg

One explanation for the smaller wholesale natural gas price decrease is that domestic wholesale gas was already very cheap.  Natural gas in the U.S. is, to a large extent, a waste bi-product of the highly profitable oil production industry, and in many cases the low prices simply did not justify the expenditure on natural gas gathering infrastructure to bring the product to market.  The ratio of oil price in $/barrel to natural gas price in $/million Btu has dropped from ~24 last summer to ~18 now, but even 18 is very high by historic standards – it wasn’t until about 2009 that a long term range of 6 to 12 was exceeded (worth noting is that a barrel of oil has about six times the energy content of a million Btu of natural gas, so at a multiple of 18 we still value oil three times more than natural gas on an energy content basis).  To some extent an oil/natural gas ratio drop from 24 to 18 is really just a small regression towards the long-term mean.

Paradoxically, the oil price drop may in some places cause natural gas prices to increase.  This is because oil production will be deferred or new wells not drilled at all, thereby decreasing the quantity of natural gas coming to market.  Less extra natural gas will put less downward pressure on wholesale natural gas prices at locations where there is spare capacity to bring that natural gas to market.  Ironically, this also means that if oil prices go up again, natural gas prices may hold steady for the exact same reasons why they were already low to being with.

International LNG prices have recently come down dramatically.  LNG contract prices in Japan, the world’s biggest LNG importer, have dropped from $16 to $10 per million BTU from last year to this, and spot LNG prices are less than $7 (in case anyone wants to redirect an in-transit LNG tanker), the lowest level in five years.  Why has this precipitous drop not had a bigger impact on domestic prices? The simple reason is that the U.S. is not (yet) tied in to the global LNG trade, and so domestic supply and demand considerations will dictate prices with minimal international influence.  For LNG importers such as Japan and South Korea, natural gas can be substituted with oil or coal as a power generation input source depending on commodity prices.  Here in the U.S. though natural gas is still a growth fuel for power generation as decommissioning of old coal plants continue.  A substitution hedge to another fuel in the short term is not really in the cards and given low domestic natural gas prices is not at all necessary.

Does a precipitous fall in global natural gas prices threaten America’s competitiveness in natural gas-intensive industries?  Not really, and certainly not enough to move the needle on domestic wholesale natural gas prices.  There has been a move over the past five or so years to expand natural gas intensive industries in the U.S., which produce outputs such as methanol, chemicals, fertilizers and glass.  Such factories are long lead-time assets and once built prefer to run at capacity.  There have been no major announcements of postponements of projects because the energy economics are suddenly more favorable elsewhere in the world (note: postponements and cancellations may occur because of corporate capital allocation considerations, but that’s a different issue).  Foreign corporate owners might shift marginal capacity between their global factories based on relative regional input costs, but this is a very small short-term effect that would barely be noticed in the domestic wholesale natural gas markets.  For the time being much of the world’s wholesale natural gas will still have prices linked to oil, and most natural gas in Europe will retain the “brought to you by Putin’s Russia” brand.  Unless there is an assurance of long-term low natural gas prices somewhere else, corporations investing in America in part because of a competitive advantage in natural gas will have no reason to change plans.

In summary, here in the U.S. we have steady supply and captive long-term demand for natural gas, and a wholesale natural gas market detached from the far more globally fungible commodity of oil.  It makes sense that natural gas prices simply won’t drop as much here as oil will in a downward oil price shock.

As for the second issue, the smaller pass-through discount, consider the difference in industries between gasoline and natural gas distribution and retailing.  Gasoline is a refined commodity with multiple suppliers, delivered via tanker trucks in a highly competitive transportation industry, and sold to us by mom and pop gasoline retailers at very narrow retail margins.  Everywhere in this supply chain, assets are substitutable and margins are squeezed by competitive pressure.  Natural gas on the other hand more closely resembles the electric utility industry.  Retail natural gas utilities such as PSNC Energy and Piedmont Natural Gas procure bulk natural gas in long-term contracts, distribute through a capital intensive distribution pipeline network, have no retail competition, and are by extension regulated utility monopolies within their territories.  It would take a new distribution pipeline, such as the proposed Atlantic Coast Pipeline, to put a long-term dent in local retail natural gas prices.  The competitive pressure in the two industries couldn’t be more different.

Personally, I’m going to enjoy the low gasoline prices while they last, which might not be for very long.  Though I would have liked to see lower heating bills this winter, I take comfort in the certainty that they will still be relatively low for many winters to come.

Daniel Kauffman, President of TerraCel Energy

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