Reversal of Fortune

In the last decade, we have experienced a complete reversal of expectations regarding the future of our domestic energy supply. Today we have the potential to materially improve both our geopolitical and economic situation.

In the 1970s it was widely believed that U.S. oil and natural gas reserves had been depleted to the point that we had no choice but to rely on imported foreign oil. Many also concluded that the U.S. needed to import natural gas. The actual experience of the last 10 years has proven key parts of these assumptions wrong.

Regulation of oil and natural gas prices during most of the early 20th century was the root cause of the errors. Oil and natural gas prices were highly regulated during most this period, primarily to keep prices low. As low cost reserves were depleted, the incentive for producers to develop more expensive new reserves was less than it would have been if prices had been allowed to gradually rise. This distortion amplified the apparent decline rate in reserves, leading to misguided energy policy which exaggerated the already volatile oil and natural gas markets.

Oil and natural gas prices were deregulated in the 1960s to 1980s. The deregulation of oil prices was fait accompli as the U.S. became a major importer of oil and could no longer control prices through manipulation of domestic production. As prices rose through the 1970s, the ensuing drilling boom developed an overhang of supply of oil and natural gas, which lasted for almost two decades, resulting in the low energy prices we experienced throughout the 1980s and 1990s. Over the last decade, as the supply overhang was depleted, we saw energy prices increase substantially.

The two decades of excess deliverable supply and low prices were also a period of limited investment in energy research and development. The energy industry was in a prolonged depression. Despite the fact that the long term outlook was problematic, politicians were not concerned because gasoline and natural gas prices were low, therefore constituents were not complaining.

By the end of the 20th century, the bonanza from the 1970s boom had been consumed. Oil and natural gas prices began to rise. As prices rose, capital investment in research and development accelerated. The results have been phenomenal!

Oil and Gas Prices Decouple

The U.S. economy is once again in a period where high oil prices are negatively impacting our economy. Oil products are our primary transportation fuels. Our oil supply remains dependent on politically unstable areas of the world.

Higher oil and natural gas prices have stimulated tremendous success in developing new supplies. The development boom in natural gas has been so successful that prices have fallen to levels that, five years ago, we thought we would never see again. As a consequence, the historic price correlation between crude oil and natural gas has decoupled. The chart below shows this dramatic change.

Oil-and-Natural-Gas-Prices

 

The difference in price per unit of energy between oil and natural gas is incredible. Natural gas is currently trading at approximately $2.00 per MMBTU (MM = million, BTU = British Thermal Units, a measure of energy content). The equivalent for oil is about $18.00 per MMBTU. At current market prices oil costs 8.9 times as much per unit of energy as natural gas.

The development of horizontal drilling technology combined with hydraulic fracturing technology has resulted in a tremendous increase in natural gas production in the U.S. This increased supply has resulted in a collapse in domestic natural gas prices. Natural gas prices are 80% below the high of five years ago. Prices are 80% lower in the U.S. than in Europe and Asia, providing our nation with a huge competitive advantage.

Increasing Consumption of Natural Gas

 

Shale-Production-of-Natural-Gas

In the early days of the oil industry natural gas was something of a nuisance. The gas was found in association with crude oil or dissolved in the oil when under pressure in the formation. As the oil was produced, the gas was also produced or came out of solution as the oil reached the surface. To dispose of it, the gas was often flared. Over time, pipeline systems were developed to distribute gas for industrial and residential consumption.

U.S.-Consumption-of-Natural-Gas-Trends-BCF

Typically the price of a commodity rises when consumption increases. But the increase in the deliverable supply of natural gas in the U.S. has been so successful that natural gas prices have collapsed while consumption increased. The increased consumption is primarily due to the use of natural gas as electrical generation fuel.

2011-U.S.-Consumption-of-Natural-Gas-by-End-Use

Lower Emission Electrical Supply

Many of the new electrical generating facilities in the U.S. are natural gas powered. Electrical generation is one of the easiest applications for the additional use of natural gas. An advanced distribution infrastructure exists for both the natural gas consumed and the electricity produced. Capital cost to build natural gas powered generating capacity is low relative to alternatives such as coal, nuclear and renewables. In addition to superior economics, there is a big bonus in that most of the generation being powered by natural gas, with significantly lower emissions, is in lieu of coal fired power plants.

Coal is currently used to generate 45% of the electricity in the U.S. Natural gas fuels 24% of U.S. electric generation.

2010-Electricity-Net-Generation-by-Sector

A recent Congressional Research Service report concluded that “if natural gas powered combined cycle plants utilization were to be doubled from 42% capacity factor to 85%, then the amount of power generated would displace 19% of the carbon dioxide (CO2) emissions attributed to coal-fired electricity generation.” According to a GE Report, CO2 emissions could fall by 150 million tons per year by year 2020 if natural gas powered combined cycle plants replace coal. This is in addition to the material reduction in air pollutants such as carbon monoxide, non-methane organic gas and nitrogen oxides as well as ash waste.

Natural gas is a much more economical option for power plants to mitigate CO2 than carbon capture and storage (CCS). For the first time in history, natural gas is cost competitive with coal.

Substitution of natural gas in lieu of coal is taking place in the domestic power generation sector. The Energy Information Administration reports that, in February and March 2011, coal-fired generators had the largest year-over-year decline, down 6.9%. Natural gas prices are even lower today than last year, so this trend is likely accelerating.

Growth Potential for Natural Gas

In some applications, natural gas can be substituted for oil products (for example, as a boiler fuel or heating fuel instead of fuel oil). Because the price differential has made natural gas so much more attractive, most of the “easy” substitution that makes sense has occurred.

Because it is a gas at ambient temperature and pressure, natural gas is not easy to store or transport by vehicle. Natural gas is almost always delivered by pipeline (not to be confused with natural gas liquids such as propane, which are used as fuel in remote areas where pipelines are not cost effective). This is why we have traditionally considered it a “domestic fuel” with our imports coming by pipeline from Canada.

LNG – Import to Export

Liquefied Natural Gas (LNG) is natural gas temporarily converted to liquid form by cooling. LNG takes up about 1/600th the volume of natural gas in the gaseous state. In liquid form, it is possible to transport natural gas by ship in cryogenic containers.

Five years ago some companies were developing facilities to import LNG into the U.S. With the lower prices today, this development has reversed and companies are now working on LNG facilities to export U.S. natural gas.

Natural Gas as a Transportation Fuel – Compressed Natural Gas

Compressed Natural Gas (CNG) is being adopted by many government agencies and companies as a fleet fuel. The lower cost compared to petroleum, combined with the reduced emissions, makes this a very attractive fuel. However, the lower energy density of CNG compared to gasoline and diesel limits the attractiveness of this option. In addition, wider spread adoption of natural gas as a vehicle fuel would require major infrastructure development in compression and pipeline systems.

Gas-to-Liquids (GTL)

Major advances have been achieved in gas-to-liquid (GTL) technology. GTL overcomes the two major disadvantages of CNG. The liquid fuels produced using this process have comparable energy density to traditional liquid fuels refined from crude oil, and can be mixed with conventional liquid fuels and distributed through the existing systems that we use to distribute liquid fuels today.

Shell is a leader in this area. Shell developed its first Pearl GTL plant in a joint venture with the state of Qatar. This facility produces 260,000 barrels of oil equivalent per day of cleaner-burning diesel and aviation fuel, oil for lubricants, and ingredients for plastics and detergents from natural gas. The first shipment of refined products from this facility occurred in June 2011. Shell recently announced plans for a Pearl GTL plant in Louisiana.

Improvement to the National Income Equation

The current economic and political discourse revolves around decreasing spending and increasing taxes. These are painful choices, but the discourse is leaving out a key component: net exports (actually imports).

In elementary economics, the National Income Equation is defined as:

National Income = C + G + I + NX + net foreign factor income – indirect taxes – depreciation where:
C = Consumption
G = Government Spending
I = Investments
NX = net exports (exports minus imports)

Decreased Government Spending decreases Consumption. Increased taxes decrease Consumption and Investments. These options reduce National Income, shrinking the economy. This is the dilemma facing policy makers.

An improvement in Net Exports (a decrease in imports; reduction of the balance of payments deficit) would increase National Income. For decades we have run a trade deficit, primarily due to energy imports. Increased domestic energy production can materially reduce imports, increasing our National Income. This would be very constructive toward growing our way out of our current fiscal dilemma.

The potential also exists to break OPEC’s stranglehold on world oil prices. Replacing 10% to 20% of U.S. oil imports with domestic oil and natural gas has the potential to materially effect on world prices. Our goal should not be energy independence. It should be to develop sufficient energy supplies both domestically and internationally that no nation or cartel can manipulate world prices.

Conclusion

The decrease in natural gas prices over the last five years once again provides indisputable proof that free market forces control the price of oil and natural gas. Massive capital investment has produced new supplies, collapsing the domestic price of natural gas at the expense of the companies that made the investments.

Current natural gas prices below $2 per MMBTU are not sustainable. The cost to develop new natural gas supplies are in the $4 – $6 MMBTU range. But at a $4 – $6 MMBTU level, natural gas would still be about one-fourth the current world price of oil on an energy equivalent basis.

Natural gas is an excellent transition fuel for breaking the stranglehold of foreign suppliers and allowing the transition time period for the development of economically viable renewable energy. Natural gas should continue to take market share from coal for electric generation. The development of export systems and systems for expanding the use of natural gas into the transportation market will further expand supply.

Most renewables being implemented today are based on 20th century technology. Current investment should be in research and development of economically viable new technology, not installing cost ineffective alternatives which reduce our national economic output. Natural gas is cost effective, produces lower emissions and is readily available in the U.S. Gas can provide an economically viable energy supply while we develop alternative energy technology.

Natural gas can be a major contributor to reducing our balance of payments deficit by reducing oil imports, and possibly oil prices. This can play a major part in easing the difficult spending/tax choices we currently face in the government sector.

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