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Sep 6, 2012

Hot Air About Cheap Natural Gas

 

Would you build a buy-and-hold financial portfolio from only junk bonds and no Treasuries by considering only price, not also risk? Not for long. Yet those who say cheap natural gas is killing alternatives—solar, wind, nuclear—make the same error. In truth, they’re doing the math wrong: the gas isn’t really that cheap.

“Cheap gas” reflects only the bare spot price of the commodity without adding the value of its price volatility. Yet such competitors as efficiency and renewables have no fuel and hence no fuel-price volatility: once built, they’re as financially riskless as Treasuries. Of course, much gas is sold not at spot but on long-term contract, especially to its biggest user—electricity generators. But for other players, it’s vital not to become the patsy in the poker game: basic financial economics says asset comparisons must value and equalize risk.

One way is to compare fuel-free competing technologies with constant-price gas. A broker will take the price-volatility risk for a fee based on the market’s risk valuation, discoverable from the “straddle”—the sum of the prices of simultaneously sold put and call options. A year ago, when the cheap-gas mania was taking hold, gas-price volatility five years out was worth more than recent spot gas prices. Even today, with lower price and volatility (whose value automatically falls with price), gas’s price volatility alone, over a time horizon appropriate for comparison with durable assets, is worth roughly what gas now sells for. Omitting price volatility thus understates gas’s true cost (excluding its fixed delivery costs) by about twofold—a very material error.

A leading promoter of shale-gas fracking, asked about this at a recent financial conference, replied, “Trust me!” Gas, he claimed, would remain very cheap for a very long time. So how much gas would he contract to sell for a constant $2–3 per thousand cubic feet for 20–30 years, backed by solid assets unlinked to hydrocarbon prices? Probably none.

Actually, you can buy gas today for delivery at least a decade hence. Sure enough, it costs 2–3 times more, or about $6. So why doesn’t a fracking promoter lock in huge profits by shorting gas futures? Because shale gas (unless sweetened by valuable liquid byproducts) has lately sold at below its cash production cost. The reasons include frenetic drilling (driven by use-it-or-lose-it leases and the need to book big reserves to raise cash), pricey oil spurring plays in oily shales, and filled storage due to a mild winter. Those low 2012 natural gas prices will probably prove as transient as the even lower real prices of 1995–2000.

The gas industry’s inherent short-term price volatility is due to weather, storage, trade, and other factors. The April 2012 low gas price rose 31% by the end of May and doubled for delivery two years hence. Uncertainties increase further out because economies are complex and unpredictable. The fracking revolution didn’t repeal basic economics: to get $6–8 gas, just assume $3–4 gas, use it accordingly, and watch supply and demand reequilibrate at higher prices.

In fact, traders’ confounded attempts to forecast supply and demand dynamics for natural gas have helped accentuate this volatility. The track record of official price forecasts is abysmal (see Figure), and private forecasts weren’t much better. Three times in the past 15 years, huge investments—such as $100-odd billion worth of mistimed combined-cycle gas turbine generators bought in the late ’90s—were painfully stranded or misdirected when gas price forecasts shifted abruptly.

Predicting gas supply and demand is unlikely to get much easier. Abundant domestic gas could paradoxically exacerbate price volatility. One reason is trade. Unlike oil, bulk gas has been delivered almost entirely by regional pipelines, de-linking prices between the major markets in Asia, Europe, and the U.S. But huge new export facilities will abruptly send liquefied gas toward the best price, rippling supply adjustments across the global network. U.S. gas, for example, may veer to Japan, where gas fetches $16 because it’s still (for now) contractually linked to oil prices. Exporters would get a windfall; other Americans would pay higher gas prices. Since major shale gas reserves are not just in North America but also such places as China, Argentina, Mexico, Australia, and South Africa, easier global capital markets or faster national  gas development could speed gas globalization, with all its benefits and travails.

Demand is no easier to predict. Finding gas in places previously “unpiped” will create additional thirst. So will competition in electricity, where gas took a tenth of coal’s market during 2005–10 (though nuclear prospects evaporated years before gas prices fell). Energy-intensive industries like petrochemicals and ammonia nimbly shift global marginal production toward cheaper gas. A trend to reward utilities for cutting customers’ bills, not selling them more gas and electricity, has spawned huge new efficiency industries; those plus new building codes in half the states are flattening electricity demand growth. Conversely, new markets are emerging: one major heavy truck maker expects 25% of its 2012 sales to burn natural gas. This tangle of savings, shifts, and substitutions further clouds the crystal ball.

Finally, add to these imponderable moving parts all of fracking’s technical, regulatory, and environmental uncertainties. Can we really believe we have irreversibly shifted to a “new normal” of low, stable gas prices, so this time will be different? The idea feels a little naïve.

To be clear, our argument is not to avoid the use of gas.  We have substantial conventional gas reserves, and may be able to economically leverage a sustainable and environmentally responsible shale gas resource, too.  But these resources should be developed prudently and used efficiently, counting gas’s full price including volatility. Doing or expecting otherwise risks enlarging the previous three misforecasts’ investment disasters.

And just as a financial portfolio manager balances yield and risk across different asset types, it’s important not to lose sight of the stable Treasuries in our energy portfolio. Energy efficiency and renewables eliminate fuel price risk. Efficiency opportunities abound worldwide wherever people and economic activity are (especially where growth is fastest, since it’s easier to build right than fix later). Efficiency has compelling economics today and an untapped potential far exceeding our newfound gas bounty. Renewables are similarly available in massive quantitities and increasingly at competitive cost, so starting in 2008 they’ve captured half the world’s market in new generating capacity. In 2011, non-hydro renewables won $225 billion of global private investment, added 84 billion watts of capacity, and invested their trillionth dollar since 2004.

We hope lingering uncertainties about shale gas will be satisfactorily resolved over the coming decade. If they are, we’ll enjoy more and cheaper gas than the futures market now believes, gaining optionality that cuts other energy risks. But if not, we won’t be unduly disappointed, because in the long run, America may not need all that extra gas anyway. Our team’s new study Reinventing Fire shows how we can harness business for profit to run a 2.6-fold bigger U.S. economy in 2050 with one-third less natural gas, no oil or coal or nuclear energy, and $5 trillion cheaper.

Now that’s an energy portfolio worthy of investment.

Lovins is Chairman and Chief Scientist, and former McKinsey & Company partner Creyts is a Program Director, at the independent, nonprofit Rocky Mountain Institute.

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Join the Discussion


Showing 1-10 of 11 comments

September 13, 2012

Thanks for another great article. It seems that the public's memory is short and reminding us all with the true facts is needed. Keep up the good work!


September 13, 2012

A prediction:

Natural gas will not remain cheap for long for several reasons:

1. The inherent environmental risks of fracking will result in more regulations, higher costs and ultimately less fracking.
2. Production from fracked wells decline rapidly, and depletion is much quicker than gas obtained from conventional drilling.
3. The reflexive move to gas for large scale uses (utilities, transportation) base on its present costs will dramatically increase demand.

The convergence of these 3 factors will result in much higher prices within a relatively short period of perhaps 5 years.


September 13, 2012

Seems to me that our Nation should be on the fast track to small nuclear reactors like LIFTR using plentiful Thorium with a liquid salt cooling core. No risk to a melt down, small, cheap and would consume the weapons grade plutonium that we have agreed to get rid of. This would generate electricity cheap for the next few hundred years or more.


September 13, 2012

With the vast amounts of coal generation that China is installing, I find this quote from the article hard to believe. Could someone provide the data to support this?

"Renewables are similarly available in massive quantitities and increasingly at competitive cost, so starting in 2008 they’ve captured half the world’s market in new generating capacity."

-Erik


September 13, 2012

Natural gas if America wants to keep it's price as low as possible then has to learn to conserve it, use it more efficiently than is being done today.
Natural gas can be consumed to almost 100% energy efficiency.
With the technology of Condensing Flue Gas Heat Recovery the energy can be recovered from the waste exhaust gases, so this recovered heat energy can still be utilized back in the building or facility.
COOL exhaust will be vented into the atmosphere.
Natural gas can be consumed so efficiently that the WATER can be recovered from the combusted exhaust gases, and this clean-distilled water is very usable.
What natural gas is not wasted today, will be there to be used another day.


September 13, 2012

Living in Marcellus Shale country and involved in sustainable development, I'm not sure of the validity of long term low cost of gas. I see it as a loss-leader and it is driving coal out of the power market. Also I am seeing powerful resistance to developing alternative energy.
Bill Sharp
Transition Centre


September 13, 2012

All: join the fracking conversation at Yale on Tuesday by submitting your questions here in advance (http://environment.yale.edu/news/article/yale-panel-to-debate-hydraulic-fracturing) or at #YaleOnShale during the livetweet.


September 13, 2012

An insightful article illuminating much under-discussed market risks that will impale the unwary. Shale gas is a very high risk roll of the dice. There are quite a few surprises-in-waiting that will add bounce, boost and breathtaking steepness to the spikes described above.

First, in order for hydraulic fracturing of shale gas formations to extort the gas out of rock, you need massive amounts of water. Problematic in a water short future. That means that we can expect the same type of mid-air collision that we saw with ethanol (food vs. fuel and now water vs. fuel). There will be a fistfight between those who demand that water supplies be safeguarded for food production and safe drinking-water purposes vs. those who want to draw off large volumes of water for hydraulic fracturing to produce gas. (A problem that is hardly bothersome to energy efficiency and supply-side clean energy technologies). (If you think with oceans acidifying and droughts increasing that there will be plenty of water, then take a look at http://www.global-warming-forecasts.com/water-supply-shortage-water-scarcity-climate.php ) and overlay those maps with shale gas production maps. Water is a no-nonsense showstopper for fracking

Second, as we approach and shoot past the 2015 IPCC greenhouse gas deadline for stabilizing emissions, there will be a regulatory burst of hammer-swinging policies and mandates implemented to flatten GHG emissions levels. That means there will be greater regulation of gas production which is a high stress source of fugitive methane emissions. Methane is carbon dioxide on steroids -- 72 times more potent at trapping heat than CO2 (http://www.global-warming-forecasts.com/underestimates.php ). Not to mention the regulatory reactions triggered by accelerating permafrost methane outgassing and Arctic ice melt headlines.

Multiple ricocheting forces will eventually intersect as gas forecasts (shown so clearly in the chart above) collide with the unsettling risks and realities of water scarcity, heat waves, hurricanes and hardline regulation.

Investors and policymakers should take a deep breath on this one.
Burnet
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September 13, 2012

Slightly off topic but the real value of gas may be the blow it gives to coal. We may get a ratchet effect. It is expensive to moth ball a coal mine but more expensive to re-open it once it has been shut down. Hopefully, mines that are closed due to competition from gas will end up being too expensive to re-open. The more renewable energy infrastructure we can install in the mean time, the less profitable it will be to re-open coal mines.


September 13, 2012

http://ronwagnersrants.blogspot.com Natural gas is the future of energy. It is replacing dirty, dangerous, expensive coal and nuclear plants. It is producing the electricity for electric cars. It will directly fuel cars,pickup trucks, vans, buses, long haul trucks, dump trucks, locomotives, aircraft, ships etc. It will keep us out of more useless wars, where we shed our blood and money. It is reducing CO2 emissions. Here are over 1,300 recent links for you:
NbaKYme3bqOw0b6KMxXSjOLHLNeflalPy9gIAiTYhttps://docs.google.com/document/d/1FMQ/edit

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