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Natural Gas Cliff

Commodities / Natural Gas Oct 23, 2012 - 07:20 AM GMT

By: Andrew_McKillop


Best Financial Markets Analysis ArticleCLIFF TOPS AND BOTTOMS
In 2004 the self-styled "environmental philosopher" Julien Darley could bring out a book with the title "High Noon For Natural Gas". With other conspiracy theorists, doomsters and media hopefuls ranging from Naom Chomsky to Michael Ruppert, Darley peddled the "US natural gas cliff". Especially the US, but also any other country increasing its use of natural gas was heading for a fall - off the cliff.

Natural gas was running out, pronto. Countries might have gas pipelines serving them, but there would soon be no gas to fill the lines. As for LNG, it was too expensive and anyway Al Qaida or ecological crazies would attack the gasification terminals or cryogenic tankers out at sea. Times were dire, but surprisingly enough the "genre material" of book publishing from Darley and Co did not sell!

Their pitch was no less than a Crisis of Civilization, they said. Gas trader did their best to lend credibility to this cute doomster theory, or at least cream some profit off it. They cranked up US natural gas prices to nearly $16 per million BTU, equivalent to oil at $92.80 a barrel in 2005 and 2006. Their rationale was either cold weather (for gas heating), hot weather (for producing electricity to run airconditioners), or simply because of Hurricane Katrina and its short-run impact on US Gulf gas production. To be sure they soon talked prices down again, to around $12 or $13 per million BTU.

In 2012 both candidates in the US presidentials, in their frequent talk about energy, energy crisis, energy prices and all the rest, are officially proud that US natural gas is cheap. The Obama administration’s Energy Blueprint, its little red book by Steven Chu for US energy policy, relies on the existence of dirt-cheap natural gas from the “shale gas revolution.”  For sure and certain, Romney has nothing against cheap gas, either.

The technology and industrial dimension counts: combining horizontal drilling and hydraulic fracturing (fracking) opened up huge shale gas resources in the US, and natural gas production jumped as a consequence. But then the gas traders, in their usual frenzy of "anticipations" or wild betting, pushed prices far below the cost of production, for far too long. The real break-even market price of natural gas in the US is maybe $6 - $7 per million BTU pricing this energy at around $30 - $35 per barrel equivalent - what we cannot exactly call "expensive energy". This didnt happen. Gas prices "tended towards zero" and the fiancial disaster for the upstream gas industry is naked. Obama and Romney did not seem to notice, or care.

When the Blueprint was released in March 2012, gas was truly dirt cheap: about $2.25 per million BTU at the Henry Hub. Gas storage levels were nearly 50% above the five-year average, due to ever rising production and because a warm winter had curtailed the use of gas heating. Market talk was of "tending to zero", of US natural gas prices falling to $1 per million BTU - giving gas buyers energy at a barrel equivalent price of $5.80 per barrel. Oil prices on the same energy markets were $100 a barrel.
To be sure a swath of predictable things happened: the Chesapeake crisis grew; XTO Energy, Exxon Mobil's gas subsidiary, purchased by Exxon at a top-of-the-market price in 2009, was doing badly; drilling cutbacks exploded and gas flaring grew; pipeline projects were cut back or abandoned. LNG export projects were dusted off and even financed - but for 5 years down the line. It was a catastrophic scenario but the price kept dropping and production kept growing.

Giving a peek into the global madness of this situation, gas importers in Europe, Japan, China and Korea were paying around $15 - $17 per million BTU in April 2012, when US natural gas prices attained their ultimate low of around $1.90 per MMBtu at the Henry Hub. US gas prices finally began to respond to the horse treatment which dragged Chesapeake, which at one time - about 24 months previous - was the ultimate investor-friendly major gas producer, very near bankruptcy. US gas prices had recovered by an impressive near-50% by May, to about $2.70 per million BTU.

The vague spectre of "the natural gas cliff" has been turned on its head: the world sits at the bottom of a towering cliff of new unconventional gas resources - both shale gas and stranded deep offshore gas. Since 2009 alone, perhaps as much as 150 years of world gas consumption at current rates (about 3000 billion cubic metres in 2011) has been found and proven. The complete refusal of governors to govern and deciders to decide has turned this windfall into a nightmare.

The economics of horizontal fracking are lurid. Any depletable mineral resource has a production profile where output drops over time but instead of years for conventional gas wells, decline rates for shale gas wells are measured in months: in a year, production can fall 80%. After 18 months by 90%. Early lifecycle output allows drillers to show a big upfront profit and as long as they keep drilling, and of course if prices do not crash. Decline rates are obscured by production from new wells but this does not hide the overall pattern of  the more wells they have, the more they have to drill to hide the drop-off in production. Add in the rabbit punch of ridiculously low gas prices, and their damage limiting response is totally predictable: gas producers switch to drilling for oil and "wet gas" or gaseous liquids yielding condensate oil, which fetches higher prices, due to oil prices being maintained at an unrealistic and unsustainable high.

The benefits and negative impacts of dirt-cheap gas in the US spread rapidly. Power producers quickly increased their use of gas - pushing the entire US coal industry into probably the worst crisis it has ever experienced. US coal consumption has fallen 25% in 12 months and coal prices from the lowest-cost stripmine producers is set at around $8 per ton, or $1.60 per barrel equivalent. Nuclear power is another collateral damage victim, being totally unable to compete with gas-based electricity production.

Companies that manufacture plastics, fertilizers, and chemicals, like Dow Chemicals using gas as the raw material are building plants in the US where they can buy their gas for a fraction of the cost anywhere else in the world. This is Obama's reindustrializing play, but take away the job losses in coal and nuclear power, the fragile finances of gas producers, and the net result is a long way from brilliant. Also, the implications for his Energy Blueprint's clean energy future goal are for the least obscure: talking about "the future being gas and renewables" sounds good, for sure, but getting their without the right decisions to limit the economic damage is impossible.

The great irony is simple, due to this refusal to decide US gas production will decline. Gas drilling activities are slowing due to brute economics and despite the "surprise recovery" of gas prices. Gas production should follow, but the reasons why this will be slow, rather than fast are long and sometimes complicated. One simple reason is the huge number of shut-in wells, waiting for "the price signal". The total number in the US is likely above 3500, and the number is still rising. Also, as if bad things can only come on a repeat basis. the shift by gas companies to "wet gas" production, to extract oil liquids. produces an increasing amount of by-product gas.

One thing is certain, the graph of falling production of US gas, preceded by the end of growing output, will meet the steep upward graph of US gas consumption, presently running at an annual rate of around 9.5%. When the two cross over, gas market traders will have another fun time talking prices up - they might even cite Julien Darley or Michael Ruppert, for a laugh!

Baleful signs of this "liberal capitalist crisis" are everywhere: nothing was done to prevent gas prices from crashing almost to zero; gas producers were almost invited to go to the wall; the coal industry was allowed to fall off the gas cliff; the coming surge of US gas prices will be totally predictable - but politicians will whine about it and talk about "protecting consumers". US gas storage inventories are now magically volatile on a downward basis: the coming heating season can blow apart the fragile - that is chaotic - equilibrium of supply and demand. US Energy Independence was a great political slogan - the problem was that nobody was in the cockpit.

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2012 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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