High Gas Prices:
The Edge
Comes Off
Conservation programs,
plus an erosion in domestic
manufacturing, will lead
to a falloff in gas demand.
November 2004
By John H. Herbert
Although there may be surprises this upcoming heating season, current high prices and past fixed investments in conservation will contribute to a decline in expected demand for natural gas in all sectors over the next several years. For major consuming parts of the country, when the cost of gas relative to an indicator of consumer budgets increases by 50 percent, residential gas demand will decline 5 to 7.5 percent on a monthly basis. This price effect could even take some of the edge off of price when demand peaks this winter.
A newer type of conservation program also should influence expected demand. Such conservation programs were initiated in Oregon by Northwest Natural Gas in late 2002 and are likely to be initiated by other utilities throughout the United States in the future.1 These programs allow utilities to receive a return for conservation gains. Utilities now have an incentive to make efficiency improvements to existing equipment and infrastructure and to work with customers to reduce usage. Previously, there could have been a cost to the utility from lost sales. The American Gas Association and the National Resources Defense Council endorsed such programs in July 2004.2
Natural-gas prices rose enough in the last several years that retail electricity in some utility service areas in the Southeast is now competitive with natural gas for such services as space heating (when differences in efficiency of natural gas and electric equipment and maintenance costs are taken into account). These natural-gas utilities could lose an increasing number of customers to electric utilities. Fixed costs associated with serving the lost customers would then be passed on to remaining customers, increasing their cost of service and further eroding the competitive position of natural-gas utilities but increasing the gains for remaining customers from conservation initiatives. Consequently, gas demand would dip because of customer losses and increased conservation investments.
Industrial Dip
Recent statistics indicate that industrial consumption of gas fell by 16 percent between 1997 and 2003.3 This trend is likely to continue in the future since industrial plants, especially manufacturing plants and other energy-intensive industries, have been hiring few, if any, additional workers; in fact, many plants continue to reduce the number of workers. Employment in manufacturing is significantly below levels experienced during the 1990s. In the energy-intensive chemical industry in New York, employment has been declining for 10 years and is now about 65 percent of its 1993 level.
Why is this important? Because when industrial plants reduce their number of employees, they often reduce the amount of equipment they use or the number of hours they operate each piece of equipment. The reduction in equipment use reduces energy demand.
Recent growth in industrial output is explained largely by efficiency improvements from better business practices and worker productivity, but some of the growth is explained by increased investment supported by low interest rates and substantial profits. Both better business practice and new equipment investment, especially when the new equipment replaces older equipment, reduces the expected demand for natural gas per unit of output.
A decline in the expected demand for natural gas in the manufacturing sector also is consistent with the relative growth in manufacturing activity overseas. The growth in manufacturing business overseas extends from chemicals to steel to concrete. The growth overseas reduces the cost of building material, clothing, and consumer staples. It therefore keeps inflation low and improves overall economic welfare. For these reasons natural-gas demand is likely to continue to weaken.
Natural Gas Expenditures and the Economy
Looking beyond this heating season, the market situation is not as bleak as many have predicted. Previously available supplies of natural gas should increase but not by much, and expected demand should get reduced. But it will still be a seller's market this heating season.
The retail price paid by residential and commercial customers this heating season will stay the same or increase, especially if utility customers are locked into recently signed long-term contracts for significant volumes of natural gas. If the weather turns especially cold for an extended period of time, things could get nasty. Instead of being at least 7 percent of monthly income for households comprising the bottom 40 percent of income, bills will be 10 percent or more when volume and price effects are taken into account.4 For the bottom 26 percent of black households, bills could increase from 16 percent of income to more than 19 percent.
High Gas Prices Drive Away Consumers
The wholesale price level for natural gas rose to a new plateau during the last several years (see Figure 1, p. 43). Accordingly, natural gas consumption is beginning to slide (see Figure 2, p. 43), as it did starting in 1973.
Following an especially mild summer storage season, early September 2004 prices were significantly reduced from month-earlier values. Unfortunately, new supplies from production sites remained tight, stopping the price erosion.
The residential customer-the marginal buyer of natural gas in the winter-sets the wholesale price at that time. If storage supplies and supplies at production sites are robust in January 2005, the wholesale price of natural gas could tumble to the marginal cost of natural gas at such times, which is still less than $3/MMBtu. On the other hand, the electric generation customer is the marginal buyer of natural gas in the summer and could set the wholesale price then at less than $3/MMBtu.5 Interestingly enough, price volatility has declined during much of the last year, but the price level has jumped more than the price volatility has fallen. Hence, at prices that prevailed this past summer the chance of a wholesale price spike above $10/MMBtu is much greater than it was several years ago.
Unfortunately, expected heating season demand has been shored up in the last several years as a consequence of additions to the existing building stock, especially homes. This effect is a direct result of 40-year-low interest rates that are slowly starting to rise. Consequently, consumer debt levels are also at historically high levels. A steep uplift in seasonal natural gas demand from a temperature drop, coupled with high consumer debt and high oil prices,6 is especially troubling.
A major increase in energy expenditures could reduce expenditures on a wide assortment of other products and services, creating a tailspin in the performance of the overall economy this upcoming heating season. Moreover, in light of the past events, some new and largely unrecognized factors will influence the shape of the market this heating season but especially going forward.
Imports and Inventories: The Backup Supplies
Because Canadian gas overall-and specifically gas demand for tar sands processing-is up, and East Coast Canadian supplies are down, Canadian imports capability until the end of December likely will get reduced yet again. Fortunately, the summer of 2004 was a very mild summer for much of the United States. Accordingly, natural-gas inventories built to very robust levels as less than expected natural gas was required to serve natural-gas power generators. Between early August and early September 2004, the daily wholesale price plummeted more than 25 percent.
Until the end of December, natural-gas utilities will tend to rely on wholesale markets to satisfy sudden shifts in demand, while closely following storage withdrawal plans. Accordingly, if the weather turns cold in November and December, the price could increase more than 30 percent over several weeks. If the weather continues to be mild and if inventories are still robust, the price could fall 25 percent or more over several weeks.
Supply
The Energy Information Administration (EIA) has reported that Alaska's North Slope has 35 Tcf of discovered natural gas resources to date, with 16 Tcf yet to be discovered.7 If a pipeline were built to flow 2 billion cubic feet (Bcf) a day, or about 900 Bcf of natural gas per year, this would represent a significant amount of incremental gas to supplement domestically produced natural gas, LNG, and readily available gas from storage. Nine hundred Bcf is about equal to the shift in demand between a relatively mild year and a cold year. EIA also has estimated that a wellhead price above $3.48/MMBtu (in 2001 dollars) or $3.68/MMBtu (in 2004 dollars) could support the planning and development of a pipeline from Alaska. But any pipeline project would not commence prior to 2006 and would not be completed until 2013 at the earliest. The exploitation of the Mackenzie Valley in Northwestern Canada has significant but lesser amounts of natural gas in place, but a pipeline from that area could be built much sooner than the planned Alaskan pipeline.
Several major LNG terminals are now moving faster through the planning stage, not only in the United States but in Canada-an indication of the tightness of the supplies and the expected sustainability of high prices. Major terminals can deliver half a Bcf of gas to market on a day.8
LNG imports were 510 Bcf for 2003 and are expected to be 710 Bcf and 820 Bcf for 2004 and 2005, respectively, according to recent EIA statistics. These forecasts will be exceeded if LNG facilities take steps to reach their cycling potential. As long as prices stay at least in the $3 to $4/MMBtu range, incentives for companies to continue
to pursue LNG investments will remain.
Other Factors That Influence Supply Growth and Price
Business negotiating skills are important for increasing supplies and reducing price. The last five years has seen growth in the number and value of limited-liability companies, including limited partnerships within the natural gas industry. These companies have tax advantages over the standard corporations that still dominate the production side of the business. Thus, they have a greater incentive to invest. Since they generally must distribute all their profits to unit holders, they are not in position to hold on to their cash. The almost instinctive industry response of not over-investing, borne out of the industry upheaval in the 1980s, would be an unnatural instinct for a limited partnership. These companies must continually be aggressive about investing if they are to grow and not lose value.
The performance of limited-liability companies has been outstanding relative to other businesses over the last five years. There is reason to believe that these flexible businesses will not only grow in number but also grow individually and thus improve the productive capability of the industry.
A recent study found that although production by major producers and major independents (none of which were limited partnerships) had declined and flattened, respectively, "smaller players have been able, on average, to increase their production levels the required 2 percent."9 These "smaller players" include the limited liability companies.
Some of the elevation in natural-gas price over the last several years is probably a consequence of many utilities entering into large fixed-price, long-term contracts. In fact, this was the strategy supported by the American Gas Association in 2003.10
Fortunately, important state regulatory commissions continue to actively support competitive markets.11 This should promote flexibility and could lead to reductions in cost of natural gas once companies are better able to negotiate with producers and intermediaries for better terms.
John H. Herbert is Adjunct Professor of Statistics at Virginia Tech and an independent consultant specializing in expert testimony, market analysis, price risk measurement and management, supply management, and investment analyses. Contact him at jhh1@msn.com.
[Editor's Note: In the upcoming December issue of Public Utilities Fortnightly, the editorial staff will be providing analysis of the coverage of FERC's Oct. 21 conference on the state of the natural gas industry. The planned meeting will address underground storage issues and other factors that differentitate natural-gas delivery and market needs.]
Endnotes
- Order No. 02-634, Sept. 12, 2002 (Ore. PUC).
- Joint Statement of the American Gas Association and the National Resources Defense Council Submitted to the National Association of Regulatory Commissioners, July 2004.
- Energy Information Administration, "Short-Term Energy Outlook - September 2004," Table A6. Annual U.S. Natural Gas Supply and Demand: Base Case. For earlier history, see John H. Herbert, Clean Cheap Heat, New York, Praeger, 1992.
- The example is illustrative but representative. The income distribution statistics upon which the calculations are based are from the United States. Census Bureau, Statistical Abstract of the United States 2003, Table 683. The Statistical Abstract also reports that consumer expenditures were more than 70 percent of gross national product in 2002. The income statistics for Table 683 are based on results for 2001, but income has not changed much for the majority of households since then. Natural gas can cost $10 per 1,000 cubic feet for many households in December and January (the EIA in September 2004 forecast the price to be $10.44 in the 4th quarter of 2004). It can be estimated from EIA data that the average household in major gas-consuming states can use about 650 cubic feet per day during height of heating season, about 10 times as much natural gas as they use in a summer month. Thus their monthly bills in December and January can readily exceed $200 (650*31days*$1/100 cubic feet). In 2001 about 16 percent of all households and 31 percent of householders between 55 to 64 years old received less than $15,000 of annual money income, or $1,250/month (their take-home income may have been less). And about 26 percent of all black households received money income less than $15,000. Thus for these households their natural gas bills were about 16 percent ($200/$1,250) of their money income. About 40 percent of all households received money income less than $2,917/month. Thus, for these households their natural gas bills were at least 7 percent of their money income. Using such statistics and then calculating how representative bills change when usage changes, taking price effects into account, one can begin to understand how rising natural gas expenditures during the heating season can lead to significant reductions in expenditures on a host of other goods and services. It also helps show why uncollectable bills have risen dramatically in the last four years. For an interesting discussion of increases in consumer debt in the last several years see the New York Times, Business Section, Sept. 5, 2004, p. 6. A graph included with the article revealed that the ratio of non-financial debt to gross domestic product has grown significantly since the year 2000 and for the first time exceeds 2.
- "This happens because the highest-price coal generating units incurring SO2 and NOx penalties cannot compete with new combined cycles, provided the cost of gas is about $3 or less. There are sufficient numbers of such units so that, once prices drop to that level, a substantial new demand for gas is created (these units displace the most costly coal units), which brings the gas market back into balance." Jeremy Platt, "Fuel Issues for Power Generation: Adapting to New Paradigms," EPRI, Energy Markets and Generation Response, July 2004.
- The relationship between energy prices and the overall performance of the economy as represented by the oil price is well understood. See for example Nell Henderson, "Greenspan Cites Oil's Restraints, Economy Otherwise Strengthens," Washington Post, Sept. 9, 2004, p. E1 quoting Alan Greenspan: "If it weren't for the oil price spike I would be very optimistic about where the economy is going." But the influence of the natural-gas price on economic performance is less well understood. This is because analysis is based on annual data in which the seasonality in natural-gas volumes, wholesale price, and wholesale price volatility is ignored. The influence of high natural-gas prices on economic performance is much greater in the depth of the heating season than at other times of the year. It is worth noting that the last time the economy entered a recession was in March 2001after the significant increase in energy bills during heating season 2000/2001.
- Energy Information Administration, "Analyses of Selected Provisions of Proposed Energy Legislation: 2003," September 2003, p. 40, SR/OIAF/2003-04. For a more complete discussion of proposed legislation supporting the Alaskan pipe build, see pp. 40-54 of this comprehensive report.
- For current and complimentary quantitative summaries of the development of an LNG industry for the United States, see Damien Gaul, "U.S. LNG Markets and Uses: June 2004 Update," Energy Information Administration, June 2004 and Stephen Thumb "All Eyes on LNG: U.S. Gas Supply Options and Prospects for Relief (Part 1)," EPRI, Energy Markets and Generation Response, September 2004. This latter publication contains a very useful LNG Supply Curve built from project information.
- Ibid. Thumb, p. 6.
- American Gas Association, June 26, 2003, which stated, "State public utility commission should pre-authorize utility requests to purchase certain volumes of natural gas at set prices under long-term contracts."
- New York Public Service Commission, "Statement of Policy on Further Steps Toward Competition in Retail Energy Markets and Statement of Policy on Unbundling," Aug. 25, 2004.
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