Hot Air About ‘Cheap’ Natural Gas

by Amory Lovins and Jon Creyts, via Rocky Mountain Institute

Would you build a buy-and-hold financial portfolio from only junk bonds and no Treasuries by considering only price, not also risk? Not for long. Yet those who say cheap natural gas is killing alternatives—solar, wind, nuclear—make the same error. In truth, they’re doing the math wrong: The gas isn’t really that cheap.

“Cheap gas” reflects only the bare spot price of the commodity without adding the value of its price volatility. Yet such competitors as efficiency and renewables have no fuel and hence no fuel-price volatility: Once built, they’re as financially riskless as Treasuries. Of course, much gas is sold not at spot but on long-term contract, especially to its biggest user—electricity generators. But for other players, it’s vital not to become the patsy in the poker game: basic financial economics says asset comparisons must value and equalize risk.

One way is to compare fuel-free competing technologies with constant-price gas. A broker will take the price-volatility risk for a fee based on the market’s risk valuation, discoverable from the “straddle”—the sum of the prices of simultaneously sold put and call options. A year ago, when the cheap-gas mania was taking hold, gas-price volatility five years out was worth more than recent spot gas prices. Even today, with lower price and volatility (whose value automatically falls with price), gas’s price volatility alone, over a time horizon appropriate for comparison with durable assets, is worth roughly what gas now sells for. Omitting price volatility thus understates gas’s true cost (excluding its fixed delivery costs) by about twofold—a very material error.

A leading promoter of shale-gas fracking, asked about this at a recent financial conference, replied, “Trust me!” Gas, he claimed, would remain very cheap for a very long time. So how much gas would he contract to sell for a constant $2–3 per thousand cubic feet for 20–30 years, backed by solid assets unlinked to hydrocarbon prices? Probably none.

Actually, you can buy gas today for delivery at least a decade hence. Sure enough, it costs 2–3 times more, or about $6. So why doesn’t a fracking promoter lock in huge profits by shorting gas futures? Because shale gas (unless sweetened by valuable liquid byproducts) has lately sold at below its cash production cost. The reasons include frenetic drilling (driven by use-it-or-lose-it leases and the need to book big reserves to raise cash), pricey oil spurring plays in oily shales, and filled storage due to a mild winter. Those low 2012 natural gas prices will probably prove as transient as the even lower real prices of 1995–2000.

The gas industry’s inherent short-term price volatility is due to weather, storage, trade, and other factors. The April 2012 low gas price rose 31% by the end of May and doubled for delivery two years hence. Uncertainties increase further out because economies are complex and unpredic-table. The fracking revolution didn’t repeal basic economics: to get $6–8 gas, just assume $3–4 gas, use it accordingly, and watch supply and demand reequilibrate at higher prices.

In fact, traders’ confounded attempts to forecast supply and demand dynamics for natural gas have helped accentuate this volatility. The track record of official price forecasts is abysmal (see Figure below), and private forecasts weren’t much better. Three times in the past 15 years, huge investments—such as $100-odd billion worth of mistimed combined-cycle gas turbine generators bought in the late ’90s—were painfully stranded or misdirected when gas price forecasts shifted abruptly.

Predicting gas supply and demand is unlikely to get much easier. Abundant domestic gas could paradoxically exacerbate price volatility. One reason is trade. Unlike oil, bulk gas has been delivered almost entirely by regional pipelines, de-linking prices between the major markets in Asia, Europe, and the U.S. But huge new export facilities will abruptly send liquefied gas toward the best price, rippling supply adjustments across the global network. U.S. gas, for example, may veer to Japan, where gas fetches $16 because it’s still (for now) contractually linked to oil prices. Exporters would get a windfall; other Americans would pay higher gas prices. Since major shale gas reserves are not just in North America but also such places as China, Argentina, Mexico, Australia, and South Africa, easier global capital markets or faster national  gas development could speed gas globalization, with all its benefits and travails.

Demand is no easier to predict. Finding gas in places previously “unpiped” will create additional thirst. So will competition in electricity, where gas took a tenth of coal’s market during 2005–10 (though nuclear prospects evaporated years before gas prices fell). Energy-intensive industries like petrochemicals and ammonia nimbly shift global marginal production toward cheaper gas. A trend to reward utilities for cutting customers’ bills, not selling them more gas and electricity, has spawned huge new efficiency industries; those plus new building codes in half the states are flattening electricity demand growth. Conversely, new markets are emerging: one major heavy truck maker expects 25% of its 2012 sales to burn natural gas. This tangle of savings, shifts, and substitutions further clouds the crystal ball.

Finally, add to these imponderable moving parts all of fracking’s technical, regulatory, and environmental uncertainties. Can we really believe we have irreversibly shifted to a “new normal” of low, stable gas prices, so this time will be different? The idea feels a little naïve.

To be clear, our argument is not to avoid the use of gas.  We have substantial conventional gas reserves, and may be able to economically leverage a sustainable and environmentally responsible shale gas resource, too.  But these resources should be developed prudently and used efficiently, counting gas’s full price including volatility. Doing or expecting otherwise risks enlarging the previous three misforecasts’ investment disasters.

And just as a financial portfolio manager balances yield and risk across different asset types, it’s important not to lose sight of the stable Treasuries in our energy portfolio. Energy efficiency and renewables eliminate fuel price risk. Efficiency opportunities abound worldwide wherever people and economic activity are (especially where growth is fastest, since it’s easier to build right than fix later). Efficiency has compelling economics today and an untapped potential far exceeding our newfound gas bounty. Renewables are similarly available in massive quantitities and increasingly at competitive cost, so starting in 2008 they’ve captured half the world’s market in new generating capacity. In 2011, non-hydro renewables won $225 billion of global private investment, added 84 billion watts of capacity, and invested their trillionth dollar since 2004.

We hope lingering uncertainties about shale gas will be satisfactorily resolved over the coming decade. If they are, we’ll enjoy more and cheaper gas than the futures market now believes, gaining optionality that cuts other energy risks. But if not, we won’t be unduly disappointed, because in the long run, America may not need all that extra gas anyway. Our team’s new study Reinventing Fire shows how we can harness business for profit to run a 2.6-fold bigger U.S. economy in 2050 with one-third less natural gas, no oil or coal or nuclear energy, and $5 trillion cheaper.

Now that’s an energy portfolio worthy of investment.

— Amory Lovins is Chairman and Chief Scientist at the Rocky Mountain Institute; Jon Creyts is a Program Director at the Rocky Mountain Institute. This piece was originally published at RMI’s Outlet Blog and was reprinted with permission.

JR — And let’s not forget the real price of natural gas ought to reflect the harm it does to a livable climate:

15 Responses to Hot Air About ‘Cheap’ Natural Gas

  1. Leif says:

    The only energy source that has shown a steady downward trend is Green Energy. Green energy would currently be the lowest by far if socially enabled capitalism were not a factor.

    Distributed green energy will only gain value as fossil energy costs increase.

  2. catman306 says:

    As will Negawatts, power saved through newly found efficiencies.

  3. Ozonator says:

    Dramatic AGW that extremist Republicans and Christians consider free speech, “Earthquake threats won’t stall fracking, industry officials say” (MARK HUME; VANCOUVER — The Globe and Mail;, 9/6/12).

  4. Leif says:

    Obama stated last night that we have a hundred years of energy beneath our feet. By the same token we have eons of free energy above our heads for only a moderate investment and minimal CO2 footprint.

  5. Paul Klinkman says:

    Fracked natural gas can be sent through pipelines to ports, where it can be liquefied and shipped to China. China is perfectly prepared to suppress any number of environmental justice riots, but after awhile the Party leadership may grow just a bit nervous of such popular uprisings. At that point they will want to switch from American coal to American natural gas, which, although it’s not technically under their land, is still their property.

    Their appetite for fracked gas should be insatiable, to the point where permanently buying our Congress, not just renting it, would make serious economic sense for them.

    Assuming that the Chinese economy continually expands through 2050, regardless of whether the life expectancy of the Chinese people rises or plummets, the earth will soon be using several times more fossil fuels than it does today.

    Natural gas is a leading cause of climate change today, probably worse than Saudi oil comparing therms to therms, because the stuff is 100% methane and it leaks away into the atmosphere like crazy. Every time the gas companies frack a dry well, all of the methane escapes. Our national network of gas pipes leaks gas at every crack, from the big transmission lines right up to that peculiar gas smell in your kitchen. Er, don’t light that match.

  6. Rabid Doomsayer says:

    Gas in a decades time, at three times today’s prices, is probably a bargain. Today’s low price is not sustainable, it must rise.

    Fracked gas well have a steep decline rate. Some gas producers must go broke very soon. Water for fracking is in short supply in many areas. Environmental concerns could lead to a severe backlash. All adds up to a quick drop in supply, but I cant give you a time-frame.

    On the demand side there is considerable investment in gas using infrastructure, so demand is likely to stay up.

    So many long term decisions are being made on a short term position. The result could be nasty and we seem to be doing everything we can to make it worse.

  7. Mike Roddy says:

    How can Amory not even bring up the issue of poisoned drinking water? Does he put a price on that?

  8. Dennis Tomlinson says:

    Natural gas (primarily methane) is colorless and odorless. The gas t-butyl mercaptan, which is intentionally added as an indicator, and is the rotten egg smell we sense.

  9. AlanInAZ says:

    Joe mentioned adding the social cost of fuels. As best as I can determine the going rate now for the social cost of CO2 is about 21$/ton CO2 emission. This leads to about .01$/kwh added cost for natural gas. This cost seems very small and unlikely to disadvantage natural gas against other non carbon energy sources. The basic problem I think is that the damages from future warming cannot be priced to reflect the true social harm.

  10. I’ve worked on natural gas supply and demand first-hand for the past 20+ years, though now focus primarily on pipeline safety.

    I’m convinced that a climate disaster is unfolding because I see the data every day. The ice cap is crumbling while the long-term demand for all fossil fuels remains unabated. The Great Recession provided a bit of a reprieve, but that will change if the economy recovers (highly unlikely in my view, but that’s another discussion).

    In any case, the visceral appetite the Republicans evince for fossil fuels is deep-rooted, almost religious, and will be a force to reckon with for a long while, backed by the incredible wealth of the fossil fuel and financial industries.

    There’s a lot of truth in this article, but also a lot of out-of-kilter assertions. I’m not criticizing the article or the authors. I’m just adding some real-world insight. To solve the climate crisis requires clear thinking and a clear view of the facts and uncertainties.

    About gas price volatility: it’s a circular thing. The authors are generally right when they add the option price of future gas deliveries to the spot price to get the cash forward price. But those option prices, too, are set by the market. So it’s a further source of uncertainty. Also, most regulatory jurisdictions include the forward price in their analysis, so it’s not uniformly ignored.

    More to the point, the forward price implicitly includes that volatility.

    The problem with volatility is the models traders use to estimate it are backward-looking, as is any statistical analysis. They implicitly assume a static status quo. They have no way to incorporate “black swan” events, like a change in technology. In other words, statistical modeling can’t predict the future in an open-ended system. That’s why gas price projections were so high in 2007–no one foresaw the sudden advent of shale gas.

    To project future gas prices for policy purposes, you have to do scenario analysis. That’s what the EIA does. You have to make certain assumptions about fundamental future conditions that the market price isn’t necessarily incorporating. The forward price curve we see daily is just the sum expression of all these analyses at a point in time, plus a lot of speculation about how people feel about this collective projection. It is a very tangled web of feedbacks, indeed.

    One of the fundamentals that seems pretty hard to argue with right now is the extent of the accessible gas resource, not just in the US but around the globe. The growth in US supply speaks for itself. We’ve gone from 49 billion cubic feet a day in 2005 to 65 Bcf in 2012, and that’s in a bad economic environment. A glance at the EIA’s map of shale resources shows how extensive that resource is. Shale is truly as common as dirt.

    There is no reason for supply to be constrained for geophysical reasons. That’s not to say it can grow forever, but the likelihood of it being cheap barring an unforeseen event is very high.

    There are real risks to supply growth. The biggest is water supply. The producers know that and are working on it–not because they’re good guys, necessarily, though some of them are perfectly reasonable, responsible people–but because they want to be efficient.

    The next is the economy. If it doesn’t recover, then production may not grow.

    The next is an accident related to water. If a major aquifer (read: New York) were fouled by a fracking chemical, there would be a very strong backlash. A lot of anti-fracking sentiment impresses me as hysterical, but that’s not to say there aren’t real concerns and that it pays to be very, very cautious and selective about where it’s done.

    As for methane seepage, the National Energy Technology Labs recently issued a report that says other reports such as those coming out of Cornell vastly overstate the problem. In areas remote from pipelines and that are focussed on oil production (like the Bakken in North Dakota), I think methane release is quite serious. But gas fracking itself doesn’t inherently mean massive methane releases. It’s a matter of regulation and money.

    I do think shale gas presents a very big risk to non-fossil power development. The producers are getting better at finding and drilling it in quantum leaps. The cost of drilling declines every passing year. Add in the ideological passion of those who want to cling to the glorious days of America’s fossil-fueled past, what James Howard Kunstler derides as the “Happy Motoring” mentality, and solar, wind, and all the rest are at risk. If nothing else, it prolongs the discussion, creates uncertainty, and allows shale gas to gain that much more traction. Not to mention shale oil.

    The economic argument for renewables is persuasive only on the individual user scale, for certain highly-constrained situations. Without battery storage or some other technology that allows baseloading (or a reasonable facsimile), fossil fuels and shale gas in particular are going to look awfully expedient.

  11. A meaningful carbon price is absolutely crucial, and you’ve put your finger on a very fundamental problem with determining one.

  12. CW says:

    Plausible, but don’t forget to factor into your thinking that China is also starting to frack for gas/oil inside its borders. Here’s a quick paragraph from Time Magazine but just Google for more obviously:

    “Now Europe and China–which together have more than twice the U.S.’s estimated shale-gas reserves–are following suit, investing billions of dollars in shale-gas drilling. China announced in March it’s aiming to produce 6.5 billion cubic meters of shale gas by 2015, and the same month the state-owned China National Petroleum Corp. signed a production-sharing agreement with Shell on shale gas. Europe is moving more slowly, though countries like gas-rich Poland are already drilling.”

  13. I should say, the economic argument without a carbon price.

  14. Solar Jim says:

    Carbon already has a price, but not in “the market.” That ultimate price is the annihilation of the Holocene biosphere by carbonic acid (liquid and gas) and the human civilization dependent on it.