The US Gas Market in Crisis

CGES | JULY 2003 | SOURCE: Global Oil Insight

“High natural gas prices could prompt the next energy crisis”, according to Alan Greenspan, chairman of the US Federal Reserve. The United States appears to have woken up just recently to the fact that high gas as well as oil prices are threatening the incipient economic recovery.

Manufacturing industries that rely on gas as their main raw material are already reducing production and laying off workers as their costs rise and further down the line the country has yet to feel the impact of higher electricity and residential heating costs on consumer spending.

Alan Greenspan is only one of a number of high-ranking US officials and politicians to recognise the importance to the country of adequate natural gas supplies. Spencer Abraham, the Energy Secretary, said recently that “high prices are a national concern that will touch virtually every American”, responding to reports that gas storage levels were close to record lows and that spot prices were double the levels of last summer.

Predictably, the rise in prices has led to allegations of natural gas price fixing and comparisons with the 2001 California supply crisis. The roots of the current crisis, however, lie in a growing mismatch between supply and demand. The US produces less gas than it consumes and relies on imports from Canada – and to a much lesser extent LNG imports – to fill the gap.

Production tends to be fairly constant throughout the year, leaving storage as the main buffer with which to supply seasonal peaks in demand. Unlike oil, there is no liquid international market which can be depended on to provide extra gas supplies at times of shortage. Moreover, while strong WTI prices have sucked in record crude oil imports this spring, high natural gas prices have barely boosted supply; instead these high natural gas prices are balancing the market by squeezing demand.

Widening deficit

Over the last twenty years, natural gas consumption in the US has increased much more rapidly than natural gas production. In 1986 demand exceeded supply by only 1 bcfd (billion cubic feet per day); however, by 1996 the supply deficit had widened to over 10 bcfd. Until recently this was not considered a major problem, for Canada has vast reserves of natural gas which were thought to be well in excess of its own domestic needs.

As recently as two years ago the National Petroleum Council’s view that “US gas demand will be filled … with increasing volumes from Canada” was widely held by the industry. However, Canada’s potential as an endless source of marginal gas supplies to the US has clearly been over-estimated.

Canadian gas consumption is rising rapidly and the country’s ratification of the Kyoto protocol last December will accelerate the shift away from more polluting fuels such as oil and coal. Another key factor is the development of the Canadian oil sands, which require large volumes of natural gas for extraction and conversion processes. Overall, most analysts agree that Canadian gas exports to the US are unlikely to increase much above the current 10 bcfd – and may even have peaked.

The only other source of gas supplies for the US is LNG imports, which currently amount to less than 1 bcfd. Fourteen new LNG terminals are planned and a few are already under construction, but thus far high costs and objections of populations in coastal areas to having large re-gasification installations near their homes have prevented many projects from getting off the ground. Even the most optimistic scenarios do not expect LNG to supply more than 2-3 bcfd of gas by 2005 out of a total US demand for gas of around 65 bcfd.

This leaves the US dependent on its own domestic gas supply, at least in the short- to medium-term. Despite an increase in drilling activity, gas production has not risen in the last five years due to a rise in depletion rates, the exhaustion of mature fields and a lack of drilling opportunities. There are now renewed calls to loosen long-standing restrictions on drilling and gas pipeline construction.

According to Spencer Abraham, 40% of the US’ natural gas resources are currently inaccessible due to environmental regulations on federal lands. “The US is not running out of gas, it is only running out of places where we can look”, claimed a spokesman for the American Gas Association recently.

Federal environmental legislation currently prevents drilling in prospective areas such as offshore Florida and the mountainous regions of Wyoming and Montana. Yet, these existing restrictive laws seem to be contradicted by recent legislation encouraging the widespread use of natural gas on environmental grounds.

The Bush administration, for its part, is trying to increase drilling on federal lands via the Energy 2003 Act – currently working its way through the Senate. However, the bill is encountering opposition from Democrats and environmental groups, which favour a move to renewable energy sources.

A new pipeline to bring natural gas from Alaskan fields to the Lower 48 states is also under consideration, but this would take up to ten years to complete – even if it were approved.

Potential demand is huge

If high gas prices persist, it is difficult to see US politicians persisting in their opposition to a relaxation of drilling regulations. Domestic US natural gas supplies could thus increase sharply once more towards the middle of the decade. However, history tells us that this incremental gas will be absorbed quickly by rising gas demand in all energy sectors driven by anti-pollution laws.

Most power stations constructed in the US since 1998 have been gas-fired. In some states gas is used for base load generation, which is normally fuelled by coal or nuclear, while high-value gas is kept for intermediate and peaking requirements. Today gas-fired stations account for 15% of US electricity generating capacity, with dual-fired oil and gas plants providing a further 19%.

The rush to gas in the electricity sector is driving the upward surge in US demand. During the period 1997-2002,natural gas consumption by utilities rose from 11.1 bcfd to 15.2 bcfd despite the stagnation in total supply. As a result, gas demand from industry has fallen in the same period, while residential and commercial use (mainly for space heating) has barely changed.

While recent US natural gas consumption has shown year-on-year declines due to tight supplies, the potential demand for gas is likely to be much higher, as indicated by this year’s sharp rise in gas prices. From 1984 to 2000, when imports from Canada flowed into the US to fill the supply gap, gas demand grew by an average 1.7 % annually, rising from 50 bcfd to 65 bcfd.

However, with gas imports from Canada at a plateau and possibly in decline, US gas consumption in the last three years has had to fall slightly to balance supply. The EIA predicts that, if gas production is revived, demand could reach 96 bcfd by 2025, almost double this year’s volume.

The US gas market is mainly regional in character due to the inherent problems of transporting gas. It is characterised by relatively long-term contracts, while gas prices in some sectors tend to be relatively invariant with respect to spot gas prices. Residential and commercial gas prices, for example, tend to respond sluggishly to movements in spot prices, whereas gas prices faced by utilities and industry are more responsive to market pressures.

High gas prices therefore usually lead to early cuts in usage in industryand the utilities. These, incidentally, are also the users most likely to have installed dual-fired capacity – that is boilers that can burn either gas or oil.

The last time gas prices spiked sharply was in January 2001, when demand outstripped supply during a cold spell. Annual data for 2001 show that gas demand fell by 3 bcfd, almost three quarters of which was due to industrial users.

The picture for utility use is more complex since any decline in demand from dual-fired plants is partly obscured by the structural demand increase from the new power stations that are solely gas-powered. However, gas consumption by utilities in 2001 rose by just 0.38 bcfd compared with an average rise of 1.1 bcfd over the previous three years, indicating that some cutbacks in demand had occurred.

The exact nature of the fall in US gas demand this year cannot be determined precisely since gas consumption data are not yet available by sector. However, it has been widely reported that industries using gas as a feedstock – petrochemicals, fertilizers and aluminium smelting are prime examples – are suffering because of high prices. Many companies are cutting their production, while multinationals are moving operations overseas, where feedstock costs are cheaper.

Additional evidence comes from oil demand data, which show a substantial increase in residual fuel oil deliveries during the first half of the year: in June alone, fuel oil demand was 45% up on the previous year. According to the EIA, fuel oil consumption by utilities is expected to rise by 28% in 2003 as a result of fuel switching.

Distillate demand is also affected, since small generators with dual-fired capacity are designed to run on diesel fuel, while gasoil can also be used as a substitute feedstock in some petrochemical-based industries. The 3.5% growth in US distillate demand during the second quarter of 2003 cannot be ascribed to either cold weather or healthy economic activity – the most likely explanation is fuel-switching.

Storage – the marginal gas supply source

Natural gas inventories have a more important role to play than oil stocks in ironing out short-term mismatches between supply and demand. Gas production rates cannot be varied much through the year, especially the output of gas that is associated with oil production.

Gas demand, on the other hand, can exhibit large seasonal variations in consumption – a difference of up to 30 bcfd between the January peak and the September low.

Unlike the oil market, in which extra supplies can be imported within one or two weeks of a price rise, the North American gas market is essentially dependent on its own production. By contrast, most of Europe now has easy pipeline access to the reserves of Norway, Russia and North Africa. Although there is a growing international trade in LNG (6% of global gas demand in 2002), worldwide imports of gas (pipeline and LNG) are still only 23% of total consumption compared with 58% for oil.

Gas remains a regional rather than a global commodity.

In the US, seasonal fluctuations in gas demand must therefore be met largely from storage. Although gas supply should balance demand on an annual basis, stocks must be built up over the summer, when gas demand is low, so that they can be drawn down in the winter when the weather is so much colder.

This past winter in the US was unusually cold (10% colder in heating degree-days than average) and the low temperatures lasted well into April, prolonging the heating season. Stocks of natural gas plummeted from 3170 bcf at the end of October 2002 to a record low of 623 bcf in the middle of April 2003. Over the previous six years the winter drawdown over the same period had averaged 1840 bcf.

Once gas inventories had fallen to such low levels, the need to rebuild them at a faster-than-normal rate started to compete with end-user demand. As a result, high gas prices have persisted into the summer months. At the end of May 2003, the volume of gas in working storage was 38% down on the previous year and 28% below the five-year seasonal average. In June 2003, a record 500 bcf was added to storage, reducing the upward pressure on prices.

However, gas inventories remain well below the seasonal norm, with only three months left until the start of the heating season. So far the gas industry has been helped by cool summer temperatures, which have kept electricity demand relatively low.

A hot summer spell, though, could quickly push gas prices up again, with a rise in gas-fired electricity generation to meet air-conditioning demand competing with the need to rebuild inventories. Normally gas inventories peak at around 3000 bcf in October or November.

To reach this volume from the current 1770 bcf would require an unprecedented rate of gas delivery into storage. If stock levels are significantly below this figure at the start of the heating season, price spikes will be much more likely over the coming winter. Three years ago, gas storage levels peaked at just 2750 bcf, leading to record gas prices over the winter of 2000-2001.

The link between gas and oil

Increasing demand for gas from the utility and space-heating sectors is pushing at the limits of gas supply, exerting constant upward pressure on gas prices. Without a flexible marginal supply source, the US gas market will remain tight and changes in consumption caused by the weather or economic activity will have an immediate impact on the price of natural gas.

In February this year spot natural gas prices briefly exceeded $10/mn BTU and they are now fluctuating between $5 and $6/mn BTU, compared with last summer’s average of $3/mn BTU.

Gas prices have always been closely linked to oil prices. The two fuels tend to be produced from the same general sources and compete in many of the same markets. Historically, gas prices have been indexed to oil prices and this is still the case in continental Europe. However, in the US this price relationship may be changing.

Federal Reserve Bank economist Stephen Brown said recently that “until there is adequate development of gas resources, gas prices will likely remain decoupled form oil through 2005”. He points out that the historical relationship linking spot gas prices at Henry
Hub to WTI suggests that gas prices should be half their current value. Moreover, Fed Chairman Alan Greenspan has noted that the long-term futures price of WTI is “at a historically rare discount to comparably dated natural gas”.

Unusually, WTI prices fell in May 2003 in response to reports of a large gas inventory build, suggesting that that they had previously been inflated by the gas shortage. What is more, the switch by some US utilities back to burning oil has pushed up residual fuel oil prices, which in turn has boosted heavy crude oil prices.

Conclusion

A widespread switch in the US to natural gas in the electricity, residential and commercial sectors is pushing against a rigid supply structure which cannot deliver large increases in gas supply when the market needs it.

With gas imports from Canada no longer increasing – and more likely to decline – the US needs to boost domestic gas production to meet growing consumption. High gas prices will eventually lead to more drilling and rising supply, but this could take six months to a year, and it may be already too late to prevent gas price spikes this winter.

The industry also faces the problem of high depletion rates in mature fields and environmental regulations that prevent drilling on federal lands.

In the long term, LNG import facilities could provide the particular source of supply needed to balance fluctuations in US gas demand, while the relaxation of drilling restrictions could boost US production. In the short term, however, gas prices are expected to remain higher than previous years, while gas inventory levels may start the winter well below normal.

This will add another upward push to oil prices as gas consumers are driven back to oil in the sectors where the two fuels are substitutes.

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