The Price Of U.S. Natural Gas May Have Found A Ceiling

The natural gas price bulls are stampeding, driven by months of lower-than-normal inventory builds and falling production.  Warm weather in early fall has not meant much demand for heating, but that has not reversed the trend of a tightening inventory.  Prices have risen to over $3/Mcf despite the current period of weak demand, and some think $4/Mcf is a likely target.  Most thought $2/Mcf this spring was too low (Berman, Rapier) but whether $3/Mcf is the new norm or $4/Mcf remains hotly debated.

The natural gas market is a case of déjà vu all over again.  In the 1980s, after price deregulation drilling brought forth abundant new supplies, pushing prices down and creating a ‘bubble’ of supply.  After five years, analysts began talking calling the bubble a ‘sausage,’ and in February 1992, the market was shocked when the price hit $1.24/Mcf (equal to $1.9/Mcf in current dollars), unheard of for mid-winter.  Again this winter, prices dropped below $2/Mcf for two months (February-March), despite the common expectation that the long-term price would be much higher (see figure below).  Those expectations were supported by declining shale gas production and the observation that inventories this summer have been returning to near-normal levels.

Survey of Natural Gas Price Forecasts 2016


Source:  Annual Energy Outlook; datapoints are interpolated.

As the figure above shows, price forecasts imply a consensus that $2 and even $3/Mcf is considered to be too low to keep the market balanced.  Of course, ten years ago, there was agreement that prices would be about $6.5/Mcf in 2015, about three times the actual as the figure below shows.  But it must be admitted that five years before that, when prices were $3/Mcf, the forecasts were much more modest, about $4/Mcf (third figure).

Survey of Natural Gas Price Forecasts 2006


Source:  Annual Energy Outlook; datapoints are interpolated.

Survey of Natural Gas Price Forecasts 2001


Source:  Annual Energy Outlook; datapoints are interpolated.

This is particularly fascinating because the North American natural gas market (U.S. and Canada) is about as close as the world comes to a free energy market and should be more susceptible to economic analysis.  Supply and demand determine prices in the long run, and traders’ perceptions of supply and demand in the short-run.  War in the Middle East, unrest in Africa, OPEC agreements, government regulations are all but irrelevant and despite repeated cries of scarcity, depletion, and predictions of ever-rising prices, the reality has been that abundant cheap gas has keep prices moderate for most of the past three decades.  The history of gas price forecasting is that consensus is untrustworthy, expectations are usually for rising prices, and the current price influences long-term forecasts very strongly.

The most important lesson of the past three decades is an old one:  the cure for high prices is high prices.  The reverse is also true, as the recent drop to sub-$2/Mcf levels and subsequent drilling decline have demonstrated.  Of course, that doesn’t explain how the drop from $8 to $3 had minimal effect on production although drilling collapsed.  (Figure below.)

Marketed Gas Production (bcf/mo) and Natural Gas Price (nominal $/Mcf)

NGPRCEPRODSource:  Energy Information Administration, DOE.

The rise of shale gas is the explanation for this counterintuitive behavior.  George Mitchell’s development of hydraulic fracturing methods for shale gas extraction meant the cost of that enormous resource plummeted, going from profitable at high prices to setting the price.  And as new shales opened up and techniques evolved further, the cost declined even more sharply and explains the current low price level.

What few seem to have noticed is that the movement from the dry gas fields in the south to the wet gas fields in the Northeast also had much to do with the continued production growth.  New Marcellus and Utica wells produce about ten times as much as wells in the Barnett shale, for example, while costing only slightly more.  Thus, as Barnett, Haynesville and Fayetteville shales went into decline, soaring production from the Marcellus and Utica more than replaced them, allowing continued increases in supply despite supposedly unsustainably low prices.  As the figure below shows, the current decline in gas production of about 2 Bcf/d compared to a year ago, can easily be made up at $3/Mcf, since at those levels, shale gas production grew at twice that rate in recent years.

Shale Gas Production Change, year-on-year, Bcf/d and Price ($/Mcf)

shalegasprodpriceData from Energy Information Administration

With the price drop from $4/Mcf in the second half of 2014 to below $2/Mcf this past winter, drilling took another hit and this time production declined, with supply in July (latest data) down 3.5% from a year earlier.  Clearly, with inventories tightening (albeit slowly), this type of decline in production could push prices higher short of a warm winter.

On the other hand, the recent increase in rigs active in the Marcellus and Utica are indicative of the likely direction of supply at $3/Mcf.  When the price was above $3/Mcf in the past, production from shales rose by 1 Tcf/yr and more.  (Figure below)  With higher well productivity and lower costs, the recent increase in drilling in the Northeast plays suggests that shale gas will keep long-term natural gas prices at moderate levels, probably below $4/Mcf.

Gas Rigs Active


Source:  Baker-Hughes, total on left axis.

Arguments that the service industry cannot ramp up activity quickly seem to be greatly overblown, considering how rapidly horizontal drilling grew when prices were high.  There is not doubt that many idle rigs are less sophisticated than those now working, but given current low utilization rates, this is unlikely to be a factor for some time to come.  Buyers should feel comfortable anticipating that, while somewhat volatile, gas prices will be moderate for many years.