The Confusion About Natural Gas Prices MAY 23, 2016 @ 08:06 AM /
Michael Lynch CONTRIBUTOR
(Part 1 in a series on natural gas prices and shale gas) With natural gas production in the U.S. having dropped two months in a row, prices have soared to the lofty level above $2/Mcf. Champagne corks are popping all over the Southwest. Well, maybe Champale. (And the various Lynch wells in West Virginia might start paying royalties again. At least enough for me to afford Champale.) But the shale revolution has meant another upheaval in the availability of resources, creating yet more confusion about long-term prices. As so often in the past, there seem to be two camps, optimists and pessimists, and not much middle ground. The pessimists, such as Louis Powers and Arthur Berman, point to high decline rates for shale wells, insist that the recoverable shale resource is exaggerated, and that production is more expensive than the consensus believes. The optimists, including this author, argue that costs are overstated and the industry is constantly improving its production methods, meaning a huge resource is available and prices will remain moderate. As a long-time price bear, I must confess that the market in recent years has surprised and confounded me. My own expectations were for prices on the order of $3-4/Mcf as a ‘sustainable’, and while this past winter was warmer than normal and no doubt contributed to recent price weakness, prices below $2/Mcf have nonetheless been surprising, even if they don’t seem sustainable. Of course, natural gas prices have rarely behaved as expected, although they have only been set by the market for three decades now, with wellhead prices for gas traded in interstate markets set by the government in the preceding three decades. Not surprisingly, deregulation led to a lot of uncertainty about their future direction since
historical behavior was no guide to future trends. In prior years, the notion of scarcity meant a belief in ever rising-prices, and the Carter Administration was more than willing to promote the gargantuan Alaska Natural Gas Transportation System (yes, ANGTS), costing upwards of $50 billion in inflation adjusted dollars, and offered to pay roughly $12/Mcf for imports. The figure below shows historical prices along with the 1977 forecast that the Carter Administration used to justify the ANGTS project, and the price offered for imports from Canada and Mexico. Carter Administration Price Trend Assumptions and Offered Prices for Imports
The free market has seen much greater gas price volatility—and much lower prices than expected. For years, most forecasters predicted that natural gas prices would rise by 5% per year above inflation, even as they peaked and declined after 1985. Since the market was recently deregulated, there was little historical behavior to analyze and my theory is that since the consensus insisted that oil prices would rise by 3% per year, and natural gas was a “better” fuel than oil, forecasters assumed that gas prices would rise faster than oil prices. The next figure shows a variety of forecasts from the Department of Energy over the years, and the way in which they have evolved is informative. The fact that all show a long-term trend of rising prices suggests that the model (conceptual or actual) estimates increasing scarcity or, in other words, depletion driving up costs. Also, it is noteworthy that only the 1995 forecast is reasonably accurate, because the market tightened from 2003-2008 (making DOE’s forecast too low for a period, something rare in natural gas forecasting).
The challenge is to understand whether the high—price period of 2003-2008 represents an interlude or the new norm. The long surplus in domestic gas (including strong imports from Canada) ended roughly in 2000, at the same time there was growing demand for gas to meet seasonally-high electricity needs in the summer. The combination created a tight market and prices well above historical levels, bringing forth a cacophony of warnings about ‘peak gas’ and long-term scarcity, with peak oil advocate Matthew Simmons prominent among them. The following figure shows how this caused an attitudinal change. The National Petroleum Council, a federally-chartered but industry-supported committee, has produced a number of voluminous studies of the domestic gas market over the years, arguably some of the best publically available (i.e., not price exorbitantly by consulting firms). In the first two studies in the 1990s, the price forecasts were quite moderate, but the high price in the 2000s made the 1999 forecast looked excessively optimistic. Reportedly, some in the industry protested and insisted that a new study be done to reflect the more pessimistic vision of supply then prevailing, and the result was the 2004 report, which argued for a much higher price (a range of $4 to $8/MMBTU in 2015) and large-scale LNG imports.
(Note: Excel has translated the date 2015 as 1905 Don’t ask me why.) It’s important not to presume from this review that natural gas prices cannot be forecast in the long term. Essentially, there are two views, the DOE-led consensus that prices should always rise, and the industry-led belief in price moderation. The latter was overturned briefly by a period of tight markets, reflecting again the lesson that longterm forecasts tend to be heavily influenced by current market conditions and that many have trouble recognizing the difference between cycles and trends. This inability to understand market forces and the high price expectations of the 2000s led to a combination of problems, especially in the upstream natural gas business, and caused some serious misadventures which were arguably irrational exuberance. The next post will discuss these in more detail. FUTURES AND OPTIONS TRADING INVOLVE SIGNIFICANT RISK OF LOSS AND MAY NOT BE SUITABLE FOR EVERYONE. OPTIONS, CASH AND FUTURES MARKETS ARE SEPARATE AND DISTINCT AND DO NOT NECESSARILY RESPOND IN THE SAME WAY TO SIMILAR MARKETS STIMULUS. A MOVEMENT IN THE CASH MARKET WOULD NOT NECESSARILY MOVE IN TANDEM WITH THE RELATED FUTURES & OPTIONS CONTRACT BEING OFFERED. SEASONAL DEMAND AND CURRENT NEWS IN COMMODITIES ARE ALREADY REFLECTED IN THE PRICE OF THE UNDERLYING FUTURES.