Natural Gas Prices Solid for $23/mmBTU?

The price of natural gas in the U.S. has about doubled in a bit less than a year despite the fact that U.S. production has actually increased by about 5%. This is due in part to new horizontal drilling techniques being applied to recently developed vast “unconventional” gas fields in the U.S. and Canada. So it might seem like the price of gas has gotten ahead of fundamentals. But there are good reasons to be bullish about gas prices longer term.

Natural gas is inherently cheap on two scores. One is that the BTU equivalency of gas to oil would price gas around $23 per Mcf, nearly double its current price. Also, gas is the cleanest burning fossil fuel, so it should be advantaged if and when carbon taxes are passed to deal with climate change.

Gas is a regional market and supplies in Europe and Japan are tighter than in the U.S. Thus prices are higher there, allowing them to outbid U.S. LNG terminals for imports, which has virtually eliminated LNG supply coming to North America. Moreover, European and Asian gas supply prospects may be even tighter after 2009, as discussed here, which would continue to preclude LNG supplies from the U.S. market absent much higher prices.

Meanwhile demand for North American natural gas is growing from a number of markets including fertilizer and Canadian oil sands production. In the future natural gas demand for transportation and electricity production will grow. A strong marketing effort to promote natural gas for buses, delivery trucks, and other heavy urban vehicles like garbage trucks, is one source of future rising demand. Reports are starting to surface of people converting cars from gasoline to natural gas, a common practice on other continents.

A second important market likely to strengthen in near future years is electric power generation. That market is turning strongly away from coal in the U.S. and Europe and toward alternatives like solar and wind which are non-base load sources, meaning they work during some days and some hours a lot better than others. When they don’t work, the generating plants must have “peaking capacity” to bring them quickly up to nameplate capacity. Natural gas is the way to obtain short term bursts of generating capacity.

An example of this was described in the Oil & Gas Journal (4/7/08) in an article about the enormous new additions to wind power being constructed in Texas and Oklahoma as follows (p.19):

“Between Amarillo and Midland, capacity factors can rise of fall by 60% within 12 hrs. So by 2011, when Texas has about 10,000 Mw of installed wind capacity, power generation might rise or fall by 6,000 Mw in half a day, requiring the sudden start-up or short-down of 15 - 20 peaking plants [powered by natural gas] to balance the load. “

Are wind and solar key parts of America’s coming energy revolution? If so, count on natural gas as well.

In the same issue a piece titled “Climate Bill Seen Raising Gas Use” quantifies the growth of natural gas that will be required for new wind and solar capacity, saying, “The Climate Stewardship and Innovation Act sponsored by Sens. Lieberman and McCain would raise gas demand by an average 14%/year against reference-case levels during 2020 - 2030.” That’s a little further out than investors need to concern themselves with. But the substitution of wind and solar for coal is happening already, spurring more gas use.

One concern about natural gas investments is the important variability caused by weather conditions. Hurricanes can destroy supplies temporarily; hot summers and cold winters add enormously to demand; and temperate weather can destroy gas demand as we have seen in recent years. Therefore it is very hard to predict what the price of natural gas will be by October, say, at the end of the summer and the 2008 hurricane season. But lately gas storage has been running a few percent below the five year average, providing a slight bullish background to the market.

In the longer term, weather conditions may be less of a factor. The fundamental bullish long term trends discussed above, less likely to be influenced by weather conditions, make me want to participate in the natural gas market, both through stocks like XTO and many others and by owning calls on long-dated natural gas futures contracts. Jim Kingsdale