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I published an article in EnergyPulse November of last year regarding stable electricity markets. The same analysis applies to natural gas – there are fundamental changes in the natural gas market structure that is amplifying the swings in market prices and shortening the oversupply/undersupply swings.

The months to expiration graph is a forward looking expression, in this case 60 months, of the relationship between the last date a producer can decide to drill a new well and have it on line (“production option”) and the last date a consumer can decide to buy gas and have it delivered (“purchase option”). As everyone in the natural gas industry realizes, that time spread is significant since the consumer can always wait until at least the day before delivery to purchase. The time spread between the expiration of the production option and the purchase option have profound impacts on the stability of a commodity market – any commodity market.

The market price axis indicates – in the producer case – what price must be obtainable, risk free, by the producer when the well will be producing for the investment to be made now or – in the purchaser case – what price must be made to win the competition for available resources on the purchase date if no other supply is added. Note that the purchase price can easily rise above the replacement cost in the short term at any time after the production option expires. This seems reasonable – once the production option expires the only way to assure purchase of the commodity is to out compete other buyers for the available resource. We have seen this in natural gas, electricity, crude oil and other commodities. In this case I have taken a two-year lead-time for the time between the decision to drill and the flow of gas to the pipe – not far off for offshore Gulf of Mexico in the existing offshore pipeline gird region, shorter for onshore, longer for deep water. This graph illustrates the reality that the ability to add new supply expires significantly before the purchaser must make the election to consume. The option to build new supply capacity cannot influence the market price for natural gas once it has expired unexercised. Unlike electricity, natural gas has never incorporated capacity charges in its structure so that open market pricing is the only revenue source for the producer (capacity charges can act as revenue assurances for producers – reducing the risk for exercising the production option and therefore the market price needed to induce investment). I would argue the old “take or pay” contracts were another mechanism that paid for reliability in that consumers “paid” for capacity even if they didn’t use it. As we saw, it ended up paying with the market paying for “too much” reliability at too high a price. A significant difference between natural gas and electricity is the presence of storage. Everyone always talks of the “influence” of storage on natural gas and the “special” nature of electricity because of its lack of storage. But why does it make the market more stable? The reason is the interaction of the storage capacity and the production option – not just the purchase option.

Storage allows the shifting of excess supply capacity from one period to another – allowing reliability to “accrue” forward as an inventory. In doing so it makes the apparent expiration of the production option occur closer in time to the purchase option, thereby allowing a closer coupling of pricing signals. If the production option is not exercised, the inventory can be drawn on. As the inventory is drawn on market prices go up, creating more incentive to exercise the production option. If the inventory can assure any given annual demand is met, then the market price will be “stretched” forward – reducing the apparent lag time between the production and purchase options. Three factors have changed in natural gas to reduce that coupling effect.

First, the amount of storage vis-à-vis the total annual demand has decreased. That means that the ability of the storage to provide multi-year shifting of supply reliability has diminished. Therefore, the apparent expiration of the production option is sliding further away from the purchase option. The producer has greater risk of shift in the supply/demand balance (what if a big new field is discovered before the well comes on line) and in the market price between the exercise date of the option and the commencement of production. Second, actual turn around time for the production process has lengthened. It used to be significant production could be found in onshore Mid-continent and Gulf Coast fields near existing pipelines. Those fields are not as plentiful today. Therefore fields must be found that are more constrained in pipeline capacity or in deeper water – increasing the lead-time to market. Therefore, expiration of the production option slides further out in the future. Third, this also means that the producer has to extend further out in the future to hedge the investment risk. The collapse of market liquidity and the increasing collateralization of transactions mean that there is a huge working capital at risk issue associated with long dated hedging. What if the producer hedges 50% of three years worth of production at current prices and prices go up 100% (can we remember last winter)? The margin call would add 1.5 times annual revenues to the investment before a single molecule flows. This is a significant factor in the investment risk decision – for if you don’t risk you have the opposite risk of a price drop destroying the expected return on investment.

The other side of the equation is the consumer. A stable open market price of any commodity only occurs when the producing community is able to invest in exercising production options at a price that the demand side of the market is willing to pay for reliable supply of that commodity. If the price necessary to incentivize investment in adequate supply is higher than the short-term price, then the market will have “boom-bust” cycles. The corollary that seems to be frequently ignored is that if short-term prices rise because of inability to get adequate supply, then the demand side will seek other methods to reduce the cost of that reliability (increased efficiency, fuel switching, etc.) Therefore, long-term supply shortages are unlikely to occur – the demand for reliability (production options) is too price elastic in the mid to long term. The implication is that natural gas is looking less and less like the crude oil market and more and more like the electricity market (though crude is getting there too – please note the SPR would not be a factor in this analysis as it is not available to the market to provide reliability except as a political decision). This does not mean we are looking at always increasing natural gas prices. In fact, the longer lead time leads to the logical conclusion that natural gas will see similar over investment in production capacity as we saw in the 1998-2002 period in the electricity market. This leads to the expectation of greater likelihood of systemic oversupply and undersupply problems. This model works well for finding the regulatory structures in the curtailment periods of the late 70’s and then price deregulation in the early 80’s – the storage system actually caused the extension of the “gas bubble” into the “gas sausage” – causing over subscription of the production option and then collapse of the open market price and volatility. The model now indicates that the swings will every bit as violent as that period just much shorter in duration.

All this being said, the model argues strongly against decade long chronic shortages. Belief that “the paradigm has changed” and “we are in a new environment” is the basis for foreclosure sales. The relationship of the lag between the production option and the purchase option works just as well in the natural gas market as it does in the electricity market as it does in the crude market as it does ….

This story first ran in substantially similar form in a recent issue of the weekly trade journal, The Desk.