Don’t Count on Cheap Fracked Gas
April 2, 2013
The oil and gas industry has long argued that the fracking boom sweeping America will lead to age of plenty where gas prices remain low indefinitely, energy is cheap and jobs are created.
But the oil and gas industry does not work in geographical isolation; it is an international industry. And increasingly the US is looking to export frack gas as LNG.
Yesterday came the first of what could potentially be many deals. The British company Centrica announced that it had signed a $15 billion, 20-year, “landmark” agreement with Cheniere Energy Partners, which would allow it to export enough from the US to supply just under 2 million British homes each year.
British Prime Minister David Cameron, welcomed the deal: “Future gas supplies from the US will help diversify our energy mix and provide British consumers with a new long-term, secure and affordable source of fuel.”
Exporting LNG to Europe and the thirsty markets of Asia could be a sign of things to come. Indeed, in the Financial Times, Ed Crooks argues that over 40 per cent of the entire US marketed gas production could be exported, if all the LNG applications go ahead.
..an industry that, having spent the last two decades denying climate change, now suddenly embraces it as a reason to produce more natural gas. So, despite the industry’s best efforts, the meme that shale gas is worse than coal is out there and being repeated again and again by opponents of shale gas drilling.
Well, at least we can say that shale gas is plentiful, cheap and American. But, then came the industry campaign to end federal limitations on the export of natural gas. What had been touted by the industry as a fuel that would help lead America to energy independence would henceforth be treated as just another world commodity seeking the highest bidder—even if that bidder is in China, Japan or Great Britain. The industry’s aim, of course, is to get higher prices for its product than customers in the United States can provide. As noted above, natural gas trades at around $4 per thousand cubic feet (mcf) in the United States. That compares to about $17 per mcf for liquefied natural gas delivered to Japan. The price in Europe is around $12.
Well, at least we can say that shale gas is plentiful and cheap. As natural gas prices declined from double digits in 2008 and the shale gas boom proceeded apace, the industry convinced Americans that cheap, plentiful natural gas was the country’s future for a century to come. And, when natural gas prices plunged briefly to $1.82 per mcf last April, even the oil and gas industry began to wonder whether cheap natural gas was really such a great thing. At that price or anything below about $2.50 really, almost no wells were profitable.
Last year independent petroleum geologist Art Berman, while reviewing the financial wreckage of the once flourishing, but now fallen shale gas drillers, noted that the industry was based on:
an improbable business model that has no barriers to entry except access to capital, that provides a source of cheap and abundant gas, and that somehow also allows for great profit. Despite three decades of experience with tight sandstone and coal-bed methane production that yielded low-margin returns and less supply than originally advertised, we are expected to believe that poorer-quality shale reservoirs will somehow provide superior returns and make the U.S. energy independent.
As Berman noted back then: “Improbable stories that great profits can be made at increasingly lower prices have intersected with reality.” The industry proceeded to abandon shale gas plays in favor of tight oil playswhich have proven to be profitable with oil prices consistently crisscrossing $100 a barrel in the last two years.
Apparently, price does matter when it comes to natural gas. And so, it seems natural gas won’t be endlessly cheap in America after all. As Berman foretold in an earlier piece, prices would have to rise to between $5 and $6 to make currently paid-for leases profitable from this point forward and between $7 to $8 to make new leases worth pursuing. For comparison, back in the heyday of cheap natural gas, the decade of the 1990s, the average annual U.S. price was $1.92 per mcf, according the U.S. Energy Information Administration
Andrew Liveris, the president, chairman and CEO of Dow, testified before the Senate Energy and Natural Resources Committee, saying an export-heavy policy for America’s newly tapped natural gas will result in higher energy prices in the U.S. and hurt manufacturing.
Liveris’ position, however, could be at odds with the direction of U.S. policy — the Energy Department is currently considering a dozen applications to export liquid natural gas — and the position of the powerful National Association of Manufacturers. At the hearing, NAM’s vice president for energy and resources policy, Ross Eisenberg, testified that regulatory hurdles to exporting should be lessened and the free market should determine how the nation’s natural gas should be used.
“What we’re calling for is letting the free market work,” Eisenberg said.
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.
Financial Times’ Ed Crooks has a piece worth reading on mounting opposition to U.S. liquefied natural gas exports. Some argue, for example, that if exports are allowed willy-nilly, the price of natural gas would skyrocket.
That controversy, Crooks writes, is one reason why the impact of the U.S. shale gas revolution in world markets is likely to be more muted than some may expect.
Natural gas, on the other hand, is poised for an upswing. “The market believes there is more room for increases than decreases,” Bolinger said, noting that the gas futures market dries up only a couple of years into the future while physical gas supply deals expose utilities to a lot of risk and tend not to stretch beyond 10 years
This makes it hard for utilities to lock in a low price for natural gas and makes the present the ideal time to hedge, according to Bolinger. In this context, utilities should see wind as a fuel saver, displacing the natural gas that would otherwise be burned, rather than as capacity, he said.
Incorporating natural gas price projections from the Energy Information Administration, Bolinger found that wind would undercut natural gas electricity generation costs in several scenarios, such as a relatively low gas recovery rate from wells. This could happen as early as 2015, making wind a cost-effective way to insulate utilities from potentially volatile natural gas prices.
Without the production tax credit, however, wind would struggle as a hedging mechanism, though Bolinger maintains it would still provide value over the long term.
Some developers have already touted wind as a hedge, according to Bolinger. He cited Kurtis Haeger, the head of planning at the Public Service Co. of Colorado, who described wind energy as “an alternative fuel, with known contract pricing over 25 years that will displace fuels where the pricing is not yet known.”
The wind (power purchase agreement) sample – consisting of 287 contracts totaling more than 23.5 GW of operating wind capacity in the U.S. – exhibits a high degree of long-term price stability. On average and in real dollar terms, the buyers of the wind energy in the PPA sample will pay no more per MWh twenty years from now as they do today. In contrast, natural gas prices are difficult to lock in for any significant duration, making it hard to capitalize on today’s low prices. Although short-term gas price risk can be effectively hedged using conventional hedging instruments (like futures, options, and bilateral physical supply contracts), these instruments come up short when one tries to lock in prices over longer terms – e.g., greater than five or ten years. It is over these longer durations where inherently stable-priced generation sources like wind power hold a rather unique competitive advantage.
Comparing the wind PPA sample to the range of long-term gas price projections reveals that even in today’s low gas price environment, and with the promise of shale gas having driven down future gas price expectations, wind power can still provide long-term protection against many of the higher-priced natural gas scenarios contemplated by the EIA. This is particularly true among the most recent wind PPAs in the sample, which likely better represent current wind pricing, at least on a national average basis. These newer wind contracts not only provide ample long-term hedge value, but on average are also directly competitive with gas-fired generation in the near term.