Saturday, January 8, 2011

The Future Price of Natural Gas

A lot of Alaska Gas Pipeline speculation focuses on the current "low" spot price of natural gas. Obviously no one wants to spend billions building a pipeline to connect Alaska natural gas to the lower 48 if inexpensive gas is available near consumers. But does the current low spot price really reflect the actual prices paid during the first 20 years of gas line operations? Probably not. To illustrate this point look at the following two examples:

1) The graph below shows the prices for NYMEX natural gas futures from the present to December 2023. These are prices that consumers of natural gas are willing to buy options to buy gas in the future. For example if you use natural gas to make steam or power or operate a heat treating furnace you might decide to secure an option to buy gas months or years in advance. When the settlement date of the contract comes up as a buyer you may elect to exercise the option or buy gas on the spot market depending on the spot price and the price paid out for the option.

Look at the futures spread to understand the direction gas prices are going. Generally the trend is up, not drastically up, but steadily up. This is probably a reflection of expectations of moderate inflation in the coming decade and the gradual shift from coal to natural gas.

Inflation in the energy sector tends to amplify - first the commodity price increases, then the cost of adding production increases as the cost of steel and labor goes up. The past teaches us that we seldom get the balance right. During times of low cost we don't invest in new production fast enough and in times of high prices we tend to over build and prices collapse. Along the way cold weather, hurricanes, accidents and disruptions contribute to randomize the settlement prices for gas. Therefore, future prices five, ten or twenty years out are only important to projects with long time lines. In the case of the Alaska Gas Pipeline the price trend is favorable.

2) What about shale gas? Last week shale gas champion Chesapeake released preliminary 2010 operating results. Those result include disclosure of their hedging positions, namely that 96% of 2011 gas production is hedged at $5.84/MMBTU and 17% of 2012 gas production is hedged at $6.19/MMBTU (Link to Chesapeake Operational Results). Previously Chesapeake has indicated a target gas price of $6.00/MMBTU, and in April 2009 Chesapeake deferred production of gas when the price was in the $4.00/MMBTU range. Updated Link: (Chesapeake presentations)

Conclusion - Expect near term (1-2 year) return to $6/MMBTU gas prices. Someone is already buying options to buy Chesapeake gas at this rate and the evidence points to this price range as the sweet spot that promotes new discovery of natural gas and further development of shale gas fields. Fortunately it's a price range that will support building the Alaska gas pipeline.

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