The world’s best roller coasters are hard pressed to match the recent gyrations in natural gas prices. From last year’s extraordinary heights, prices plunged 42% in one month, swifter than for most commodities, and a huge surprise to many analysts. Do recent price movements make sense?
For more than a decade, ‘up’ has been the norm for natural gas prices. At just over US $2 per million British thermal units (MMBtu), mid-1990s prices were low enough to entice North American businesses and households to substitute heavily into the plenteous, clean-burning fuel. Prices responded, moving to US $3.20/MMBtu in the 1998-2002 period before leaping to US $7/MMBtu in the fast-paced 2003-07 period. Prices averaged US $8.90/MMBtu in 2008, peaking at US $13.31 in July. Since then, prices have melted and today are hovering in the US $3.30-3.40 range.
Analysts can be forgiven for overreacting on the upside. Steady price increases held US consumption in check in the 2002-06 period, but production hit a bigger snag, falling 6% during the same interval. Imports from Canada didn’t help, at the same time falling 4%. The apparent dearth of domestic supply sparked frenzied investment in a spate of liquefied natural gas (LNG) import terminals at a number of US ports. As such, LNG imports surged by 145% in the 2002-06 timeframe, making up the shortfall.
Investment wasn’t confined to imports, though. Unperturbed by gloomy data on North American gas reserves, investors ramped up US natural gas drilling by 17% annually from 2004-06. The activity paid off: in 2006, US production edged up by 3% after falling in each of the previous five years. A further 3% was added in 2007, and in 2008 US production surged by 8%, the largest gain since 1984.
Were the geologists wrong? Hardly; conventional reserves are still a problem. But unconventional reserves, long known to be substantial, have only recently become economically viable. Horizontal well drilling together with the more recent innovation of multi-stage fracture stimulations have opened up vast quantities of gas in thick shale formations to exploration and development. Increased production of shale gas was key to last year’s surge in total US production, and recent developments in Texas, Arkansas and other states bode well for future production growth in the Lower 48.
So far, a classic case of elementary economics: tight supplies boost prices, high prices boost investment, increased production brings prices back to equilibrium. But are today’s sagging prices actually in equilibrium? Not exactly. Unfortunately for the industry, increased supply coincided with the largest economic contraction in six decades. As such, demand for gas has swooned by 5% to date this year, on a 13% drop in industrial demand. For the moment, prices are abnormally low.
Prices are expected to remain subdued while the world economy works through the current period of weakness. In response to soaring inventories, gas producers have scaled back activity, but are expected to ramp up again as the recovery takes hold. As we march through 2010, prices are expected to climb back to the US $5-6/MMBtu level, enough to kick-start production again.
The bottom line? Surging supply and stifled demand have pummelled natural gas prices. Consumers will enjoy the brief hiatus, but producers can look forward to more normal pricing in 2010.