How Did Natural Gas Get to $15?

The futures contract for natural gas for delivery in January 2006 is currently over $15 per million BTUs. The same contract traded under $8 this time last year, and that was high compared to historical averages of $2-3/MMBTU. Its current price equates to $90/barrel crude oil and suggests that our natural gas supplies are even tighter than for crude oil, since the two commodities were trading at a rough energy-equivalent parity until recently. While this is partly a function of icy cold weather in the Northeast and the extended recovery from this year's hurricanes, the causes go much deeper.

The switch by industry and utilities from oil to natural gas played a key role in resolving the energy crises of the 1970s and early 1980s. US gas demand has grown steadily ever since. Natural gas now accounts for 18% of total US electricity generation--50% more than in 1991--and has dominated new electric generating capacity construction for more than a decade, as a result of the tremendous improvements in combined cycle gas turbines and the impact of environmental regulations restricting power plant emissions. This will be an even more important factor in the future, because of the low greenhouse gas emissions of natural gas-fired power plants.

Unfortunately, investment in gas resource development and pipeline infrastructure has been more sporadic, and this wasn't helped by industry forecasts as recently as 1999 that anticipated ample future supplies to meet the expected rapid growth in demand. When power plant developers chose gas-fired technologies over coal or other alternatives, they did so with reasonable assurances that the gas would be there for them at an affordable price. Calpine was one of the companies that placed big, strategic bets on this proposition, and those bets are now coming due.

So over the course of a few years, we've gone from an expected surplus to a serious shortfall, and that didn't just happen because of some hurricanes in the Gulf Coast. The decline of US oil production and the oil industry's understandable shift to looking overseas for larger production opportunities is an important factor. Reduced domestic oil production decreased the potential for "associated gas", i.e. natural gas produced from crude oil reservoirs. Combine that with more rapid decline rates from mature gas fields and the drilling bans and other restrictions I've been railing against since I started this blog, and we have the perfect setup for a gas crunch. The twin storms of 2005 merely hastened its arrival by a year or two.

The only mitigating factor today is that the key gas-consuming industries in the Gulf Coast were as badly affected by the hurricanes as the gas production itself, with the result that the levels of gas in storage for winter have been about normal for this time of year. That stored gas won't last long, though, if industrial demand returns to normal while supplies remain shut in. I doubt we'll experience residential supply interruptions, but companies that rely on gas may face actual interruption of deliveries, not just high prices. After a few months of that, I suspect those proposed LNG import terminals won't look nearly so scary.