by Belinda Petty, Enerdynamics Instructor

Last week’s blog post discussed how and why fundamentals rule natural gas pricing. Following up on that discussion, here are a few examples of events or scenarios that in recent years have been game-changing on both the natural gas supply and demand sides.

Rockies oversupply
During the early 2000s, a new era of gas supply growth developed in the Rockies. Producers began drilling coalbed methane. This new dry gas source was quick to drill and easy to standardize without the need for lots of new processing plants. While area and regional demand absorbed some of the new production, supply quickly outstripped demand by 2005. Rockies prices, which had been rising in concert with national natural gas prices, began to fall.

By 2007 Rockies prices had dropped by more than 30% to less than $5/MMBtu, and some spot prices fell dramatically to as low as $0.05/MMBtu. Rockies producers had to do something to change the market fundamentals or they were all going to be broke!

By the late 1990s some producers, knowing a fundamental supply and demand mismatch was coming, began to discuss a new pipeline to move Rockies gas east. In 2004, the Rockies Express Pipeline (REX) construction began. By the time the first phase of REX received gas in 2007, Rockies supply far outweighed the demand. Rockies prices still traded at a significant discount to the rest of the market.

When Phase II came on line in 2008, Rockies prices flew up in response to the additional markets now accessed by the new pipeline capacity. The additional markets shifted supply from the Rockies to the Midwest, pushing out more expensive Gulf Coast supply and eroding the overall national price level. When Phase III opened new markets to Rockies supply all the way to the Ohio/Pennsylvania border, Rockies prices began to move in unison with the rest of the gas market.

The graph below compares the growth in production with the impact on Rockies regional prices during REX commissioning. The market saw the imbalance coming, but the lead time to react took longer than the growth of supply. Building pipelines, storage, or distribution systems take long periods of time due to regulatory requirements and capital commitments. So there is often a timing mismatch between a major market change and getting the assets in place to absorb the change.

Increase in natural gas electric generation
Overall gas supply in the U.S. has grown dramatically for the last five years. The growth has come as success in drilling shale formations has boomed. Initially, the new shale volumes were concentrated in the southeastern parts of the U.S., specifically in Texas and Louisiana. New supplies caused downward overall pricing pressure but were absorbed into a robust network of pipelines and markets accessible to Gulf Coast supplies.

However, as the Marcellus shale in Pennsylvania began its prolific rise in production, the supply and demand imbalance resulted in a fundamental shrinking basis between northeast prices and Henry Hub as well as Henry Hub gas prices falling from $4 to $2/MMBtu over the course of 2011.

But, as fundamentals change, markets adjust. Declining gas prices pushed natural gas into parity with coal as a fuel source for electric generation. Typically when gas prices drop below $5/MMBtu some inefficient coal units can no longer compete with gas generation, and as prices drop below $4/MMBtu fuel switching to gas becomes dramatic. As gas prices fell, electric generators accelerated the switch from coal to gas as the fuel of choice for generation. The new demand absorbed a huge supply overhang allowing prices to stabilize to today’s level.

Regional Marcellus supply basis shifts
Regardless of the overall supply balance position, regional factors can impact locational pricing in dramatic ways. This has been the case in the Marcellus shale basin at various points since 2011. The Leidy supply hub is the most recent example. New production has been building upstream of Leidy since 2009. In 2012, new production had grown to the point where no unused transmission capacity was available to move incremental gas to market. Producers began competing with each other to ensure their gas would flow.

Gas prices eroded to a one-day low of $.05/MMBtu. Market participants scrambled for ways to alleviate the bottleneck. From the first of 2013, new gathering, processing, and pipeline capacity has been built to allow the majority of production to move. With the last of a new 1Bcf/d tranche of transmission capacity commissioned on Nov. 1, 2013, Leidy pricing has shifted from a -$1.45 basis to Henry Hub to a -$.40 price basis to Henry Hub. The supply/demand balance has been restored with assets in place to move the majority of gas to market. Again, the time to get regulated assets in place took longer than the time needed to develop the production, gathering, and processing.

What does this say about the future?
Given the price instability we’ve discussed, is natural gas a reliably economical fuel source over the long term? Or is it too risky and are prices likely to rise soon? No one knows for sure. Variables include:

• new asset and capital commitment
• whether shale producers will continue to find and produce cheap supply
• whether environmental concerns will curtail shale production
• how quickly natural gas demand will grow
• and whether natural gas exports will become significant.

A recent modelling effort by Stanford University[1] suggests that under most scenarios it is likely that prices will stay below $6/MMBtu over the next decade. But keep your eye on the changing fundamentals — as history has shown a change in fundamentals can result in dramatic shifts in natural gas prices.

References:
[1] See Changing the Game? Emissions and Market Implications of New Natural Gas Supplies, EMF Report 26, Volume 1, September 2013, p. 23 (available at http://emf.stanford.edu/files/pubs/22532/Summary26.pdf)