Sunday, October 01, 2006

The Supply and Demand behind Natural Gas:

As natural gas prices have fallen from 15 to the mid-4 range, I thought it would be a good idea to do a initial overview of the natural gas industry, as well as the economic consequences of the recent decline in price.

First, a general overview of the demand for natural gas. In 2005, consumption of natural gas was 21.9 trillion cubic feet. To give a historical perspective, demand for 2000 was 22.2 trillion while in 1980 it was 19.9 trillion. (Appendix A, B) Their are four major sources for natural gas demand: Residential, commercial, industrial, and electric power. Residential and Commercial consumption has always remained relatively constant, as fuel efficiency has negated any increased demand. Therefore, the major sources of consumption increases over the past few decades have been from industrial uses and electric generation. This has been augmented by the huge misbalance that used to exist in the relationship between the price of natural gas and crude oil. Up until 1980, this ratio traded at an 18:1 ratio, compared to the 6:1 ratio of their energy content. As regulation has loosened, this ratio has steadily adjusted downward as companies made the switch to the more cost efficient natural gas. By the late 90's, this increased demand brought the ratio to a more appropriate average of 7:1 by the late 90's. Since 2000, this ratio has very closely following 6:1. That is, until now.

Crude oil is currently at $63, while natural gas is at 4.50, for a ratio of 14:1. This is just speculation, but the prices of natural gas and crude oil have probably traded so closely in recent years due to hedge fund arbitrage, rather than true economics. Thus, the recent break in the relationship could also be a result of their trading and the unwinding of severe loss positions from companies like Amaranth. Due to the huge divergence in their respective prices, one might expect more demand to emerge for natural gas as it switches from crude oil. Unfortunately, this might not be true (at least not any time soon).

The following excerpt from Alan Greenspan describes the elasticity of these four sources of natural gas demand.

"Residential and commercial prices of natural gas respond sluggishly to movements in the spot price. Thus, to the extent that natural gas consumption must adjust to limited supplies, most of the reduction must come from the industrial sector and, to a lesser extent, utilities."

So, if you were to look for increased consumption, it would have to arise from industry or power generation. I speculate that we will not see a surge in demand emerge anytime soon. My first cause arises from the fact that until '97, the ratio of natural gas prices to crude oil favored the switch for industrials to natural gas. Since '97, the price has hovered close to the 6:1 ratio. Thus, I would
believe that most businesses before 1997 that could switch to natural gas have already made the switch, and they would have had little reason to switch back to crude oil since then. This leaves only the small possibility for increased demand from those industrials that were able but never made the switch, or those businesses that started since 1997 that decided to go with petroleum. With respect to utilities, their power generation and consumption has been growing steadily for several decades. Since natural gas prices have been at hitting new high's recently, I would find it hard to expect any abnormal surge in natural gas powered plants. This is especially true when you take into account that coal has become far more cost competitive, even after carbon reduction requirements. I will keep a close eye on link A below regularly over the next several months to see if my beliefs are indeed true.

Now, for supply. The supply side situation is far more difficult to predict, but at least we can use it to establish a sort of "floor" price for natural gas. Consumption in the US has been satisfied recently by increased imports from Canada, and help from decreased demand due to increased fuel efficiency. Depletion rates (a given years production as a percentage of reserves) have recently been at 27 percent, according to Alan Greenspan. This is higher than usual, and the very motivated or industry experienced might want to see how much of this depletion is occuring to the lowest cost production and how much of the reserve replacement is happening at higher costs. I was unable to find any data regarding that though, so I will rely on the current information I do have. Industry operating costs are currently running at about $1.00 per mcf(Appendix E), making this the extreme worst case scenario price. A severe recession and severe glut in supply would have to occur for prices to reach anything near this area(the possibility of which should never be discounted fully). A more likely scenario though would also take into account finding and development costs, which are basically the amount of money per mcf that companies must invest in order to establish new reserves. FD is currently at approximately $1.50/mcf, and adding in operating costs establishes a reasonable "floor" value at $2.50/mcf natural gas. But even this scenario assumes a lot of negativity. Natural gas companies would no longer be profitable, and supply would have to replace the 27% depletion and probably any increases in demand in the future. I admit my ignorance to this supply situation. I do know many companies have been able to increase their reserves at costs of about these levels, yet I have no idea how long this may persist. In all reality, this may be the best number to use, but I would turn to a 3rd and probably better number - the cost of LNG imports. As many of you know, natural gas is not easily transportable, and in order to ship from foriegn countries it requires or either to be pipelined or converted to LNG and shipped. According to EIA, "the minimum costs range from $3.40 in Baja California to $4.64 in the Pacific Northwest"(Appendix D). Assuming this scenario would take out any concerns over inability to add supply. I would highly recommend readers to use at most $4.50/mcf as the base case in evaluating their investment ideas, and as always look for a significant margin of safety under those circumstances. Using this is not perfect; more industry competent people can probably come up with a far more precise number to use in their calculations, and it is very likely that this could be even below the $4.50/mcf I assume. But for the many people who rely on what they hear from the media or touting analysts, this number is far safer then assuming scenarios of $7, $8, or $10 gas. Remember, preservation of capital is always key. And to make things even more convenient, $4.50 just so happens to be natural gas' current price.

A. September 2006 Natural Gas Monthly
B. Historical Natural Gas Annual
C. Historic price of Crude Oil
D. Current Natural Gas and LNG Projections
E. Peters and Co. Oil and Gas Conference- Encana

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