You have probably noticed almost every consumer good has gotten a lot more expensive. Economists argue about the many causes of inflation, but it always boils down to the relationship between supply and demand. Usually, it’s about the supply and demand for currency against the overall needs of the economy. Today, you hear more and more about the supply chain impacts. It appears to be a mix of both.
When it comes to natural gas, the supply and demand dynamics are what you should watch. Everyone probably knows the price of natural gas has been and remains extremely volatile. Looking at the history of prices shows wild volatility leading up to 2005, when the Federal Energy and Regulatory Commission (FERC) reported all time high record prices for the fuel came from a supply shortage. FERC didn’t know that combining horizontal drilling with hydraulic fracturing was already changing the supply outlook so that 2005 was the peak price year followed by 15 years of price declines including lows not seen this century. The Frackers is a great book covering this point in history, but we are at another historic moment now.
Unlike 2005, supply constraints are unlikely to be relieved by a breakthrough technology to unlock rapid supply growth. Some think the price of natural gas price moves are random.
Price moves may be very difficult to predict, but they are not random, but rather an outcome from a very dynamic market with constant supply and demand imbalances. If the industry cannot identify a supply boosting technology, price declines are at the mercy of demand destruction. It may feel like a roller coaster, but the factors which are likely to make volatility biased to the upside are numerous. Turning the electricity industry into its biggest customer is a major factor.
Our Electricity Industry Made a Concentrated Bet on Natural Gas
When supplies of natural gas started to swamp demand, prices fell and producers went bankrupt. During this time, a rush to take advantage of the low prices led to building electricity generation which used natural gas. Within a little more than a decade of time, natural gas became the most popular source of electricity generation while the electricity industry grew to become the top customer for natural gas.
What needs to be questioned is whether the new codependency between the natural gas and electricity generation industry creates a level of fragility in price stability and system reliability which is sensible. In most industries, fewer suppliers, higher financial leverage, limited storage/buffer stock, bankruptcies in the supplier food chain, and dependency on single technologies represent major risk factors. Natural gas is not immune from these factors. Consider:
Natural gas prices have seasonal peaks: There were strong seasonal usage peaks in summer and winter before electricity generation became the top use. Turns out electricity usage also peaks in summer and winter so the new peaks are more extreme. Note how 2022 usage is beyond the 5-year average for the July peaking period. This wouldn’t be a big problem if the infrastructure for storage and transportation could keep up, but it didn’t. The country has the same amount of storage and pipeline permitting and construction do not look easy. So every time we come close to running out, prices spike upward.
Natural gas industry bankruptcies are high: When consumers enjoyed falling prices and grew the industry to new records for most of the last 10 years, the natural gas producers financially struggled to invest in a growing industry where wells have short useful lives and rapid depletion rates. The rationalization of the industry was the result of the growth spurt. The remaining players should be stronger, but less likely to invest for the short-term even as prices race upward because they intend to survive for the long haul. At the end of 2020, the Oil & Gas industry had the highest amount of liabilities under Chapter 11 bankruptcy (over $200 billion dollars). When the number of competitors dwindle, prices tend to move upward.
Financial markets are turning their backs on fossil fuels: The institutional investors have become very focused on ESG (Environmental, Social, Governance) themed investment goals. Natural Gas is often cut from consideration for investment and lending by the mainstream financial institutions. ESG’s initial focus was on coal; however activist attention has broadened its focus onto all fossil fuels. Market analysis don’t see the winds shifting in this trend and eventually all fossil fuels will carry the same stigma that was once reserved for coal. If funding for key vendors is curtailed, their prices typically rise.
Contrasting risk appetite between two major industries: Electricity is a monopoly heavy industry with a premium on reliability and stability, not to mention fuel pass through clauses that mean the utility company is rarely exposed to price volatility. Natural gas production is full of wildcatters going from boom to bust throughout its history. Some exposure between the two may be just fine, but for the two to become each other’s largest customer or vendor means asking the stable one to absorb a whole lot of naturally occurring risk of the unstable other. As evidenced by the recent desire for the natural gas industry to serve the new ultra-high war premium prices of the Asian and EU markets via LNG shipping. Fitting for the nat gas industry, but it will likely make supply issues and prices work against the stability and reliability goals of most electricity markets. When the risks of disruption or insolvency increases, prices tend to move higher.
These risks tend to compound over long periods of time and will likely drive price volatility. The more that is invested in assets designed to run 25 or more years on this technology, the harder it will be to avoid the price volatility. When volatility is up, the financial pain will rise and our nation’s productivity will suffer. It is simply no longer prudent to hope for natural gas prices to trend downward with the confidence we had 10 to 15 years ago. Let’s get off this roller coaster and diversify away from this technology for electricity generation.
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