Natural gas is a combustible mixture of hydrocarbon gases. In its purest form, natural gas is almost 100% methane. Natural gas is colorless, shapeless, and orderless in its pure form. As a precautionary measure, mercaptan is added to natural gas before it is delivered to the end-user so that it can be smelled in case of leaks. Natural gas is a lot like oil in gas form, since it helps power the world, be it through fueling transportation, electricity generation or residential/industrial heating. Until the middle of 2008, natural gas prices were skyrocketing, driven by high oil prices, stabilizing or declining gas reserves near high-consuming countries, (ex. countries like the U.S.), and a general run-up in fuel prices. The financial crisis of 2008 broader, global economic slowdown and excessive supply has caused and growth for Nat Gas to fall into the negatives.
Who Benefits From Rising Natural Gas Prices?
The oil and gas majors all represent solid investments to play the rise in natural gas prices, including Exxon Mobil, BP, Chevron, CONOCOPHILLIPS (COP), Total S.A. (TOT), and Royal Dutch Shell (RDS’A). Other large oil and gas companies include Lukoil (LKOH-RS), ENI S.p.A. (E), Repsol YPF S.A. (REP), and SINOPEC Shangai Petrochemical Company (SNP).
Other companies that stand to gain from a rise in natural gas prices include:
- NiSource owns the largest natural gas pipeline in the U.S. through a subsidiary, Columbia Gas Transmission. NiSource serves nearly 3 million customers along the Eastern corridor, and provides services across the natural gas value chain, including storage, transmission, distribution, and marketing.
- Dominion Resources, also a large player in nuclear energy, owns North America’s largest natural gas storage system.
- Sempra Energy offers an interesting play by combining a utility company, which provides natural gas to 20+ million customers in Central and Southern California, with a natural gas storage, marketing, and transportation business. Sempra also owns and operates a series of liquid natural gas assets and pipelines throughout North America.
- EnCana has focused on unconventional natural gas exploration and oil sands exploration and development. Unconventional resource plays show small recoverable reserves on initial assessments, but have the potential for huge returns if new extraction technologies can be successfully developed, and if prices are high enough to make the required investment worthwhile.
- Cabot Oil & Gas (COG) owns a portfolio of both conventional and unconventional onshore natural gas properties in North America.
- Patterson-UTI Energy (PTEN) provides natural gas companies with contract drilling services. As the price of natural gas increases, demand for PTEN’s services also increases because the sale of natural gas becomes more profitable.
- Gazprom (GZPFY) is the largest extractor of natural gas in the world. Gazprom owns more than 75% of Russian and most of eastern Europe’s natural gas reserves.
Who Loses From Rising Natural Gas Prices?
- Electric utilities who don’t own their own sources of production are especially exposed to increased natural gas prices. As a result, where possible, electric utilities are vertically integrating, owning transmission assets at the very least, and often exploration and production assets as well. When prices are rising, utilities suffer from shrinking margins, as there is a delay between the time prices start to rise and the time regulators decide to raise rates. Gas utilities include Alliant Energy (LNT), AGL Resources, Atmos Energy, Energen, Equitable Resources, National Fuel Gas Company, ONEOK, Sempra Energy, Southern Union Company, and National Grid Transco.
- Liquefied Natural Gas (LNG) is the big disruptor in this market, and could change the landscape of companies who benefit from natural gas. LNG is natural gas that has been liquefied, making it easy to store and transport. Those with large asset bases in Texas and Louisiana, notably Exxon Mobil and BP, would face increased competition from overseas competitors in Russia and the Middle East in the event that LNG technology becomes cheaper and/or achieves some economies of scale in the U.S. This would also reduce the value of pipeline assets owned by the likes of pure-play pipeline companies such as Kinder Morgan. Companies with LNG terminals, or in the process of planning or constructing LNG terminals include: The Korea Gas Corporation, The Tokyo Electric Power Company, Inc., Enagas S.A., Chubu Electric Power Co., Inc., Sonatrach, Royal Dutch Shell, Osaka Gas Company, Qatar Petroleum, Petroliam Nasional Berhad, and Tokyo Gas Co., Ltd, Sempra Energy, Total S.A., El Paso, Equitable Resources, and Southern Union
Economics Of Natural Gas
The natural gas value chain looks similar to value chains for many other fossil fuels, consisting of exploration & production, processing, transportation, additional processing, marketing/distribution, and ultimately, delivery to end users. Historically, the natural gas industry has looked a lot like the electricity industry– a natural monopoly (due to the high capital costs of natural gas pipelines and difficulty in storing natural gas), heavily regulated at both the wholesale and retail levels. However, unlike the electricity industry, deregulation has been a boon to the natural gas industry, encouraging innovation and reliability of supply.
The key drivers of the end-user price of natural gas are two-fold. (1) The raw fuel costs account for about 60% of final costs, while (2) the transmission and distribution costs account for the remaining 40%. The raw fuel price is market determined, but is driven by a combination of market demand and both current and future supply of natural gas. Natural gas is unique in that it is challenging both to transport and to store, limiting the short-term flexibility of supply in response to demand shocks.
There are typically two methods of transporting natural gas, both requiring significant investment. The predominant method of transportation in North America is via natural gas pipelines. An increasingly popular method of transport, and one likely to continue to gain traction as the U.S. finds itself importing more natural gas from sources outside Canada, is Liquefied Natural Gas (LNG), which enables gas to be shipped overseas in tankers. LNG requires major investment in both deep-water, sheltered ports to harbor LNG tankers and in liquefaction and gasification plants on both ends of the transport route– as of March 2011, the U.S. had 10 LNG terminals.
Gas storage also offers an opportunity to reduce the cost of natural gas. Natural gas prices are typically seasonal, peaking in the winter months and hitting lows in the summer months, when heating needs are least. Though storing gas is challenging, given that it is lighter than air and therefore prone to dissipation, solutions have been found. Typically, gas is stored in depleted natural gas/oil fields or underground aquifers. In times of abundance (i.e., summer) gas can be injected into storage facilities, only to be withdrawn again during times of scarcity. The state of storage capacity and technology has a significant impact on natural gas prices in both the short-term (as stocks of stored natural gas represent the most readily available supply in case of increased demand for natural gas) and the long-term (as increased storage capacity offers the opportunity to build up more substantial reserves of easily accessible natural gas).
Energy Equivalence And The Oil/Gas Ratio
A barrel of oil contains roughly 6 BTUs of energy equivalence, so based on the idea of energy equivalence, natural gas should trade at one sixth the price of oil. When gas trades above its theoretical energy equivalence value, the oil/gas ratio falls below 6, and when gas prices fall, the oil/gas ratio rises above 6. In theory, when the oil/gas ratio is above 6, there is an arbitrage opportunity available from purchasing gas and selling it when prices revert to the energy equivalence value. For example, on May 29th, 2009, the oil/gas ratio was near 18x, the highest it was in 9 years. (For example: With WTI oil trading @ $75/barrel on NYMEX, Nat Gas “energy equivalence” pricing would be $12.50/MMBtu on NYMEX. Further, while in theory there is an “arbitrage opportunity” in practice it’s a bit more difficult. Both commodities trade via future contracts, therefore “time” becomes a factor for any position held. Also, both commodities exhibit a great deal of intra-day price volatility).
Oil Supply, Demand And Pricing
This correlation is driven by two key factors. First, oil and natural gas are substitutes for many end-users, especially industrial and transport consumers (residential consumers do not have the choice to “switch” to petroleum powered stoves). Second, natural gas and oil often are found in the same geologic formations, and therefore, as oil prices rise, encouraging more exploration and production of oil, typically, exploration and production of natural gas increases as well. However, the US fulfills more than 65% of its oil needs from imports, triple that of natural gas, changing the supply/demand fundamentals between the two sources of energy. That means that oil prices are more dependent on rising demand internationally, especially in countries like India and China, while natural gas prices are more dependent on rising domestic demand (until late 2008) and slowing growth in North American supply.
Natural Gas Supply And Demand
During the week of July 14th 2008, it was revealed that natural gas inventories had gained 104 Bcf; on July 17th, shares of natural gas producers fell as investors made a run on the gas market. Later, in September 2008, a report by the IEA predicted natural gas imports will reach about half of world demand by 2015; though the OECD North America will still produce 90% of its own natural gas, imports will double. Because of the 2008 Financial Crisis, however, natural gas demand had been falling since the summer of 2008. In September, demand for natural gas declined by 2.62%, according to the EIA. As excess supply in North America can’t be cheaply shipped to other countries, falling domestic demand has translated into rapidly falling prices and reductions in gas drilling. Data from July 2009 shows that the number of drills operating in the U.S. is down by 55%, or 851 rigs, year on year. This reduction in production, however, should help bring prices back up rapidly once demand starts to increase, as there will be a lag between the time demand starts to rise and the time enough rigs are in place for supply to catch up.
In December of 2009, the Independent Energy Agency (IEA) stated that world natural gas demand will increase from 3 trillion cubic meters (TCM) in 2007 to 4.3 TCM in 2030. Reserves of 180 TCM are expected to be sufficient for 60 years at current world consumption, however the agency states that almost half of world production capacity will need to be replaced by 2030.
Expanding Liquefied Natural Gas (LNG) Demand Means Higher Natural Gas Prices
During 2009 & 2010, there was enough liquefied natural gas plants set to come online to expand global natural gas supply by 30%. If global gas demand increases for environmental and economic reasons, LNG can supplement domestic sources. (LNG breakeven for 2009 from Qatar to America is $2.50MBTU) What effect this additional supply will have on current future prices is unknown at this time.
Source Of Supply
Over the past ten years, approximately 85% of natural gas imports into the U.S. have come from Canada. Canada’s reserves, however, are beginning to dry up. This presents a problem, because Canada has been an advantageous trading partner for the U.S., given its stability and the established network of transcontinental pipelines providing a low-cost distribution network for natural gas from Canada. The potential for supply disruptions is considered by financial markets in projecting the future price of natural gas. The United States holds only 3% of the worlds proven reserves of natural gas, compared to 28% for Russia and 40% for the Middle East. As we import more of our natural gas from overseas, the cost of converting and distributing liquefied natural gas will represent more of the gas’s end-user price.
From September 2008 to March 2009, the number of natural gas drilling rigs operating in the U.S. fell from 1,606 to 884, because of the contraction in gas prices that occurred following July 2009.
Weather & Seasonal Fluctuations
Natural gas demand observably fluctuates on a seasonal basis, falling in summer months and rising in winter months. The need for heat during the winter and lack thereof during the summer are the primary factors responsible for these fluctuations. Seasonal anomalies, like cooler summers or warmer winters, can dampen this effect and change the amount of gas demanded on a large scale, thereby affecting natural gas prices, revenues, and profits. Utilities that purchase gas when prices are lower during the summer months, in order to keep inventories ready for the winter, also have a muting effect on natural gas seasonality. Recently, however, fears over repeatedly bad hurricane seasons have led to higher prices because of their track record of causing supply disruptions. The U.S. is particularly vulnerable, since approximately one third of domestic production of natural gas resides in Louisiana and Texas, where hurricanes are likely to land.
Drilling And Storage
Both drilling programs for new gas discoveries and storage of existing reserves of natural gas heavily influence natural gas prices. Typically, the stock of natural gas in storage is crucial heading into the winter months, when natural gas is typically withdrawn from storage. Drilling programs, which increase in number when gas prices are high, lead to increased discoveries and/or production of natural gas in 6-18 months, depending on complexity of discovery and extraction. Therefore, drilling programs are more likely to impact medium to long-term prices for natural gas. As resources on land mature and deplete, drilling in deep water and coal-bed methane extraction has increased in importance.
The Ethanol Effect
Ethanol mandates around the world (including the U.S. Energy Independence and Security Act of 2007) have driven up demand for the corn-based fuel (cellulosic ethanol is still a developing technology). Ethanol is distilled in refineries that use gas boilers – and it takes 30,000 BTU of the stuff to produce a single gallon of “green” fuel. In other words, a 50-million-gallon-per-year plant uses 5 billion cubic feet of natural gas; with corn-based ethanol production in the U.S. alone set to increase to 15 billion gallons per year by 2022, it is ironically a response to environmental energy issues that could drive natural gas demand (and prices) through the roof.
Gas Exporting Countries Forum [GECF]
In late 2008 a major change occurred in the global energy industry when the previously informal association of countries in the GECF — Gas Exporting Countries Forum — transitioned to a more formal status by adopting a formal charter and opening offices in Doha, Qatar. The GECF is comprised of 15 member countries and control 75% of the world’s natural gas reserves. Russia is the leading member and is the world’s largest producer of natural gas, while other members include Iran and Qatar, which hold the world’s third largest and fourth largest reserves respectively. Energy industry and political analysts are probing the question of whether the GECF can or will function as a “cartel” for natural gas and thus significantly influence global energy markets.