What drives natural gas prices?

Why do we care? Well, for one thing, because it’s relevant for understanding the market for electricity. Recent estimates are that about 25% of US electricity usage is met by burning natural gas in gas-fired electricity plants.

But also there’s been some buzz around natural gas recently. You may have read about hydraulic fracturing (“fracking”), for instance. The bottom line is that natural gas is low cost today, by historical standards. It’s also cheap relative to other energy sources like home heating oil and gasoline, if you were to compare them on an energy-equivalent basis. As the price of gas has crashed since the beginning of the 2008 financial crisis, the stock values of gas production companies and gas pipeline companies have also fallen. Some market observers think this means gas prices will be rising soon; others think we should settle in for a long period of cheap natural gas. The actual path of future natural gas prices will influence the cost of electricity, especially in the northeast.

So what factors influence the price of natural gas, and where do we think they are headed? Where gas is headed depends on your opinion about what really drives costs. In this post, we provide background on general gas fundamentals. At the end of this post, you will find links to interesting information, and technical expertise.


Background on Natural Gas Fundamentals in the US

The main story is that huge new supplies of gas are coming online, thanks to a new extraction method called hydraulic fracturing or “fracking.” People who live in the Northeast are generally aware of the large quantities of fairly “clean” (at least, cleaner than coal) energy locked up in the Marcellus Shale, for example. Local newspaper accounts have focused mostly on the employment and environmental impacts of exploiting this resource. But there are other large reservoirs of natural gas in the United States that can be tapped by fracking, notably the Barnett Shale in Texas. The size (large) and location (close to pipelines and/or major population centers) of these “new” (in fact, these deposits have been known about for a while, it’s just that the hydraulic fracturing technology has only recently made them reachable at an reasonable cost) resources has some people excited about the prospect of a new era of energy independence for the US.

Natural gas futures - through Aug 2012

The impact of all this on the price of natural gas has been predictable: more supply and relatively flat demand have meant lower prices. (The US financial crisis and the recession that followed also contributed to lower gas prices.) For some historical perspective on this, consider that one important local gas price index (NYMEX Henry Hub) ping-ponged between $5 and $15 per MMBTU (million British Thermal Units — to visualize the energy in one million BTUs, think of it as containing the same amount of heat energy as 8 gallons of gasoline) in the four years from 2005 through the end of 2008. By comparison, the average price of this same natural gas index over the past 50 days has been about $2.50 per MMBTU, which puts it near the bottom of the range for prices since the beginning of 2009 (the range during this more recent period extends from just under $2 on the low end to about $8 at the top).

Some Factors that Influence the Price of Natural Gas in the US 

But natural gas is a complicated commodity, and as a result, our basic understanding of supply and demand doesn’t necessarily get us to the right answer, especially in the near term. Here are a few main reasons why.

Timing. 

Natural gas supply and demand are mismatched in time: demand is highest in winter, and it typically exceeds supply during the heating months in the northeast and midwest. However, in the summer months, demand is lower than supply. So you’d think that gas would be really expensive in the winter and cheap in the summer, right? And you’d be wrong. This is because of . . . . STORAGE (see below).

Storage. 

The uneven and somewhat unpredictable level of demand for gas, and the resulting seasonal mismatch between daily usage and production mentioned above, means that gas has to be stored. Lots of natural gas is stored, waiting for when it’s needed — which is another way of saying that it’s waiting until the price is right to sell.

Distribution. 

For the most part, natural gas has to get moved from where it comes out of the ground to where it can be used or stored. This requires a lot of pipes. The US has a pretty significant natural gas distribution infrastructure (over 300,000 miles of pipeline!), but it doesn’t go everywhere. Building and maintaining underground gas pipelines is expensive, and the companies that own the pipelines charge gas producers to use them.

Weather. 

Like electricity prices, the price of gas is influenced by the weather. In particular, extreme weather (hotter or colder than usual) has the potential to really affect gas prices. For example, the very warm 2011-2012 winter in the Northeast led to lower demand for gas to heat homes, and this meant that less gas was drawn down from storage than during a “normal” winter. Partly as a result, storage inventories for gas were at record highs when the heating season ended in the spring. If they remain this way heading into the 2013 winter heating season, it could mean lower gas prices.
Summer weather that is hotter than expected can also lead to more gas demand, because gas-fired electricity generators are often used to supply the peak summer demand from air conditioners. So a hot summer, like the one that we’ve had across the United States, may mean less gas in storage come fall, and if this is followed by a colder-than-expected winter, can produce a price spike. One way to think about it is this: more volatile weather means more volatile gas prices.

Domestic Production (supply). 

Supply can be controlled to a degree by the energy companies that extract the gas from their wells in the ground. If they see that prices are low and may remain low, they might choose to store more gas, reduce production or shut it off entirely, hoping to sell if prices rise later. The number of new wells being drilled and the number of wells in active production changes all the time because of these kinds of decisions. Some producers may face pressure to sell gas even at prices they don’t like because they have to make debt service payments on the money they borrowed to drill the wells in the first place. All of this makes it complicated and difficult to predict future gas prices.

Imports (supply). 

Despite the significant amount of gas we have here in the US, we do import gas (about 16% of total consumption was imported in 2007, for example). We get gas from Canada and Mexico via international pipelines, but we also import natural gas that is shipped in special tankers, and which is called Liquified Natural Gas or “LNG.” This LNG generally comes from oil-producing countries, because natural gas is often a by-product from oil wells. Roughly 25% of the electricity generated in the US comes from natural gas. Because it’s typically more expensive than coal (actually, recently gas prices went low enough to reach parity with coal prices on an energy-equivalent basis), energy generators tend to turn on their gas-fired turbines only when they have to meet a spike in demand (for example, when a summer heat wave hits and electricity demand jumps because everyone is running their air conditioners full tilt).

Another thing about the demand for natural gas: it takes a while for energy consumers to adjust their behavior to benefit from lower natural gas prices, and this makes the usual relationship between supply and demand hard to predict (economists would say that demand for gas is “sticky”). For an extreme example of this, consider that right now natural gas costs about a tenth of what gasoline does, on an energy-equivalent. How would you like to fill the tank on your SUV for about $6? Sounds good, right? Think about how difficult it would be to convert a significant number of cars in the US from gasoline to natural gas–natural gas demand doesn’t adjust to prices in a smooth, frictionless way.

Economic activity (or inactivity). 

Much of the decline in natural gas prices over the past 4 years can be attributed to the 2008 financial crises and the economic recession that followed. The slow US recovery from this recession and the long-simmering European debt crisis have likely also done their part to keep prices low. Like a lot of commodities, prices rise when the global economy is firing on all cylinders, and fall if it stalls. This is because households and businesses generally use more energy when times are good, just as they tighten their belts when times are hard and the future is uncertain.

Trading and Speculation.

Trading and speculation effects are technical factors too, and there is some evidence that their influence on the price of gas is growing. Trading and speculation are the two main financially-motivated activities in the commodity market. Trading behavior that is not speculative would generally come about because someone needs to hedge against a change in the price of gas. They are trying to reduce their risk. Speculators, on the other hand, are trying to make money and are consciously taking on risks (placing bets in the market) to do so. The amount of hedging and speculation in the gas markets has increased in recent decades, in part due to deregulation and innovation in finance. There are new, electronic exchanges where gas can be traded, and there are new financial products that allow traders/speculators to go far beyond simply buying or selling gas in the “spot” market. For example, there are natural gas futures, natural gas derivatives, and natural gas investment funds. By one estimate there is currently 12 times as much trading of natural gas in purely financial markets as there is natural gas physically trading. [http://www.naturalgas.org/naturalgas/marketing.asp] Given all of this, it’s not surprising that financial trading activity can affect the price of gas.