Email This Author Comment On Article About The Author More Articles By This Author

INTRODUCTION:
Two recent articles caused me to review the issues associated with natural gas supply and electricity pricing. The purpose of the review was to determine the impact that a shortage of natural gas would have on electricity pricing. In addition to the simple supply and demand issues, it is interesting to speculate on how natural gas pricing might impact other potential fuels such as fuel oil, coal and nuclear generation. To complete the overall equation it is necessary to examine the potential for fuel switching that might impact demand for natural gas and reduce the upward pricing pressures. NATURAL GAS SUPPLIES:
The Energy Information Administration (EIA) recently published a somewhat optimistic forecast for natural gas supplies. In their report they indicated that production levels in 2003 would average 51.4 billion cubic feet per day and that this figure represented a 10% margin over the demand level. In their report they cautioned that the storage levels were low and that many of the new wells that were being drilled had only about one year of supply associated with them. They also indicated that any extraordinary increase in demand for natural gas could be problematic. Overall, they appeared to be attempting to put a positive spin on a problem. In their article they did not allude to the fact that more than 100,000 MW of new natural gas fired power generation is currently under construction. Almost all of this new generation will be coming on-line in 2003 or 2004. I have made a fairly simplistic calculation of the impact associated with this new demand.

1. If one-half of the new generation (50,000 MW) is base load equipment and it is planned for operation 75% of the time then the demand for natural gas will increase 12.4% over current levels.
2. If the other one-half of the new generation (50,000 MW) is peaking equipment and it is planned for operation 20% of the time, the demand for natural gas will increase another 4.7%.
3. When the total impact of these two increases in demand are computed, the total demand increase will be 17.1% over current levels.

In the EIA study they indicated that the marginal capacity available is 10%. Clearly, all of this new capacity cannot get its natural gas fuel without causing severe supply and demand problems and increasing natural gas prices.

A DISCUSSION OF ELECTRICITY MARKET MECHANICS:
It is clear that demand for a product cannot exceed the actual supply amount. What actually occurs is that as the demand increases to nearly the supply levels the price rises and users have to make decisions.

1. Industries may decide to curtail production if the price of energy rises to some specific level. Clearly, the U.S. economy suffers when this takes place.
2. Product prices rise to compensate for the higher energy costs. This approach also has a negative impact on the U.S. economy.
3. Industries that use natural gas may be able to switch to either fuel oil or heavy oil at a lower price. The price for switching depends on the price of the other two commodities.
4. Supplies of natural gas may be increased through the construction of Liquified Natural Gas terminals at suitable deepwater ports. This action will increase the supply side of the equation and rebalance the market. Currently there are proposals to develop as many as 12 LNG ports around the U.S. It is fairly widely expected that natural gas from these facilities would have a floor price of about $4.00/million btus. If these ports are to be commercially successful it will be necessary for natural gas prices to average at least $4.00/million btus.
5. The high price for natural gas will encourage the development of alternative power generation options such as coal, geothermal and nuclear. In fact, the market is already looking at building new coal-fired facilities. The price for energy out of a modern coal fired plant may range between $0.045/kWh to $0.05/kWh. These plants face significant environmental hurdles, but these hurdles will be overcome by price considerations.

It is interesting to note that under all of the scenarios that can be created, many of the new and under construction merchant natural gas facilities will remain idle. These plants were based on projections that natural gas could be delivered for under $3.50/million btus. A second mistake would be to construct several LNG ports that could not deliver natural gas for less than $4.00/million btus unless the market is convinced that other alternative will not push the market price below these levels. Coal priced electricity, therefore establishes the maximum viable price for base load natural gas at below $3.50/million btus. This price can only be achieved if demand is reduced to a level that provides for a reasonable level of margin in the market without constructing LNG ports. THE IMPACT OF OIL PRICING ON THE MARKET:
At the other end of the market, natural gas is the primary fuel for short-term electricity generation. This power can be provided using conventional boilers, combustion turbines, and reciprocating engines. The price for #2 fuel oil sets the standard for units that can do fuel switching. The target price for Crude oil is about $28.00/barrel of oil. A single barrel of oil contains 42 gallons of oil. Number 2 fuel oil sells at a 0% to 15% premium when compared to Crude oil on a seasonal basis. It also has the advantage of being storable. Using this measuring stick, the cost for #2 oil could be $32.00/barrel or approximately $0.76/gallon of oil. Based on 130,000 btus/gallon of #2 oil, this results in a price of $5.86/million btus of fuel. Therefore the maximum sustainable price for natural gas before a significant level of fuel switching begins to occur will be between $5.96/million btus and $6.00/million btus. THE REAL STORY OVER THE LONG-TERM:

1. Bringing in LNG to satisfy the long-term market will only work if coal, nuclear and geothermal generation cannot provide for the long-term, base load, electricity needs. Since coal is generally available and is priced very reasonably, I would expect to see the development of some new coal fired power generation with suitable environmental controls over the next several years. This trend will continue until natural gas prices can be expected to remain below $3.50/million btus. At that point, the price for natural gas generated electricity will be equal to or below the price for coal fired generation.
2. As coal plants are built the natural gas equation will return to normal and will reach $3.50/million btus. At this point some of the over-built natural gas capacity will get back to a reasonably high utilization level and these projects will return to a profitable level.
3. For the next several years peaking plants will be subject to high pricing levels. For plants that were built using duel fueled equipment, it will be possible to switch to oil when the price of natural gas exceeds $5.86/million btus. Unfortunately, many of the combustion turbines that were installed for peaking were not provided with the duel-fueled capability. These units will risk being blocked out of the market by the duel-fueled equipment.
4. Eventually the price for bulk supplied natural gas should return to a level around $3.50/million btus with the short-term price exceeding $5.86/million btus on a seasonal basis.
5. Coal fired generation cannot be readily constructed in many places due to environmental concerns and reactions. But, the delivered price of energy on a wholesale basis to utilities from newly constructed coal plants can be expected to be approximately $0.05/kWh. This will tend to establish the market price for new base load electricity. New coal generation is faced with significant environmental hurdles making construction of these facilities very time consuming and potentially more costly, depending on the level of coal fired power plant emissions reductions required.
6. Geothermal plants are also capable of producing energy for approximately $0.05/kWh. The development of these plants can be expected to accelerate significantly because of their superior environmental advantages. With the potential for new tax legislation and the environmentally friendly nature of this zero-emissions, 100% renewable, firm, base-load power generation, it is likely that as much as 20,000 MW of new geothermal generation could be developed.
7. Nuclear plant development remains even more unpopular than coal plant development. Therefore, it would appear that there is still only limited potential for this type of development.

HEDGING STRATEGIES:
The first and best hedging strategy will be ownership in existing hydro-electric, coal and nuclear power generation. Companies that have a strong position in these technologies will be protected from the negative side of the natural gas created price spikes and will be able to take advantage of the potential profits that may exists. There are several other hedging strategies that might be profitable in the current energy market:

1. Ownership and development of base load geothermal plants should be a safe and profitable long-term strategy for production of base load generation. The development of these projects can be done more quickly than coal projects at similar costs to coal plants. Additionally, these projects are not subject to such unknown costs as truck/rail transportation variations and environmental law changes.
2. A second potential hedging strategy is related to wind project development. Wind projects currently enjoy some significant tax benefits that make it possible to deliver wind energy at less than $0.04/kWh.

Unfortunately wind is very unreliable and has an availability of approximately 33%. Wind curves can be created to indicate the times when wind is most likely to be available. But these curves also show that the peak electricity demand periods of the day are not necessarily associated with the peak availability of the wind power resource. I believe there is a strategy that could take advantage of the wind availability and tax benefits while providing firm capacity to the marketplace. This strategy is described below: EXAMPLE:
A 50 MW wind form is constructed at an average sale price for the electricity of $0.039/kWh. The projected availability is 35% of the 8760 available hours or approximately 3,000 hours/year. These hours will occur randomly during the year. At the same time the constructor builds a 50 MW reciprocating engine plant using a multi-fueled engine approach. The engines that are used can be selected to use either 100% liquid fuel or 20% liquid fuel and 80% natural gas. There are a number of variations that could be possible from this configuration.
a. 20% bio-fuel and 80% natural gas
b. 100% bio-fuel
c. 20% diesel fuel and 80% natural gas
d. 100% diesel fuel
e. 20% bio-fuel and 80% diesel fuel
The fuel selection could be based on the best pricing and environmental scenario available at the time of operation. Engine exhaust cleaning systems are available now at reasonable prices that would even allow the use of diesel fuel at environmentally acceptable and cost effective conditions. Bio-fuel is a form of biomass and will qualify for any future Production Tax Credit. Bio-fuels can be produced from waste oils or can be produced from virgin feed stocks made from selected grains. The concept that would be considered would be to offer the market a firm renewable project that would operate five days/week for 12 hours each day. This power sale basis is typically referred to as 5 X 12 power. The total number of hours of firm operation would be 3,000 hours/year. The reciprocating engines would operate 2,000 hours/year. The total installed cost for the engines would be approximately $450/KW. Use of current financing would create a capacity cost of $0.025/kWh of energy produced. The typical O&M for this type of equipment is approximately $0.012/kWh. This brings the estimated fixed cost to $0.0375/kWh based on 2,000 annual operating hours. Based on this total, 1,000 hours/year of the generation would be provided by wind energy at a price of $0.04 and 2,000 hours would be provided by the reciprocating engines at a price of $0.09. The other 2,000 hours of non-firm wind energy would be sold to the market at $0.04/kWh. Specific pricing structure is detailed below: The fuel cost will depend on the need for environmental credits, the cost of bio-fuel and the tax benefits that are available to biomass projects. If we assume that 100% bio-fuel is available in the marketplace at $1.30/gallon then the cost for fuel for this project would be $10.00/million btus of fuel or $0.09/kWh. This would bring the total cost of electricity to $0.1275/kWh for 2,000 hours of reciprocating engines firing bio-fuel, with a cost of $0.04/kWh for 1,000 hours of wind power, for an average of $0.0983/kWh for the 5X12 block of firm peaking energy. The average annual cost for the wind/reciprocating engine 100% renewable option would be $0.075/kWh, based on 1,000additional hours of wind generation at $0.04/kWh This price might be considered well above the market, but it has the advantage of being 100% renewable. There is a possibility that the bio-fuel could be produced using recycled oils only. If this option was used the price of the bio-fuel would be reduced to about $1.00/gallon. This would reduce the cost of the reciprocating engine generation to $0.106/kWh and would reduce the average 5 X 12 price to $0.0845/kWh. It would reduce the annual average generating cost to $0.0667/kWh. This would represent a firm 5 X 12 component with an additional 2,000 hours of non-firm energy. The price for energy would be reduced further by using other fuel combinations such as those shown above, but it would lose the advantage of being 100% renewable. The lowest potential cost combination would be to utilize a combination of 20% diesel and 80% natural gas along with the 1000 hours of wind energy. CONCLUSIONS:

1. The projections that have been made by the federal government and the natural gas industry indicating that there is a sufficient natural gas supply and that it will be reasonably priced are seriously flawed.
2. Construction of LNG ports to increase natural gas supplies based on power generation demands may also be seriously flawed and also represents a significant potential security problem and terrorist target.
3. The projection is that natural gas, over the long-term will return to average price levels at around $3.50/million btus. The long-term projection may be 10 years out at the earliest.
4. In the mean-time a reasonable hedging strategy that has good long-term potential would be to construct new coal and geothermal facilities that reduce the demand for natural gas, stabilize the price and eventually relieve the natural gas demand problem, thereby driving the price back down to competitive levels.
5. There may also be a good hedging strategy associated with the construction of a combination of wind and reciprocating engine equipment. The multi-fuel nature of the engines will provide for fuel price protection as well as provide a renewable character to them. The wind will provide low cost renewable energy. The combination of the two sources of energy will provide firm energy supplies during the peak demand periods