Hot Air About Cheap Natural Gas
Would you build a buy-and-hold financial portfolio from only junk bonds and no Treasuries by considering only price, not also risk? Not for long. Yet those who say cheap natural gas is killing alternatives—solar, wind, nuclear—make the same error. In truth, they’re doing the math wrong: the gas isn’t really that cheap.
“Cheap gas” reflects only the bare spot price of the commodity without adding the value of its price volatility. Yet such competitors as efficiency and renewables have no fuel and hence no fuel-price volatility: once built, they’re as financially riskless as Treasuries. Of course, much gas is sold not at spot but on long-term contract, especially to its biggest user—electricity generators. But for other players, it’s vital not to become the patsy in the poker game: basic financial economics says asset comparisons must value and equalize risk.
One way is to compare fuel-free competing technologies with constant-price gas. A broker will take the price-volatility risk for a fee based on the market’s risk valuation, discoverable from the “straddle”—the sum of the prices of simultaneously sold put and call options. A year ago, when the cheap-gas mania was taking hold, gas-price volatility five years out was worth more than recent spot gas prices. Even today, with lower price and volatility (whose value automatically falls with price), gas’s price volatility alone, over a time horizon appropriate for comparison with durable assets, is worth roughly what gas now sells for. Omitting price volatility thus understates gas’s true cost (excluding its fixed delivery costs) by about twofold—a very material error.
A leading promoter of shale-gas fracking, asked about this at a recent financial conference, replied, “Trust me!” Gas, he claimed, would remain very cheap for a very long time. So how much gas would he contract to sell for a constant $2–3 per thousand cubic feet for 20–30 years, backed by solid assets unlinked to hydrocarbon prices? Probably none.
Actually, you can buy gas today for delivery at least a decade hence. Sure enough, it costs 2–3 times more, or about $6. So why doesn’t a fracking promoter lock in huge profits by shorting gas futures? Because shale gas (unless sweetened by valuable liquid byproducts) has lately sold at below its cash production cost. The reasons include frenetic drilling (driven by use-it-or-lose-it leases and the need to book big reserves to raise cash), pricey oil spurring plays in oily shales, and filled storage due to a mild winter. Those low 2012 natural gas prices will probably prove as transient as the even lower real prices of 1995–2000.
The gas industry’s inherent short-term price volatility is due to weather, storage, trade, and other factors. The April 2012 low gas price rose 31% by the end of May and doubled for delivery two years hence. Uncertainties increase further out because economies are complex and unpredictable. The fracking revolution didn’t repeal basic economics: to get $6–8 gas, just assume $3–4 gas, use it accordingly, and watch supply and demand reequilibrate at higher prices.
In fact, traders’ confounded attempts to forecast supply and demand dynamics for natural gas have helped accentuate this volatility. The track record of official price forecasts is abysmal (see Figure), and private forecasts weren’t much better. Three times in the past 15 years, huge investments—such as $100-odd billion worth of mistimed combined-cycle gas turbine generators bought in the late ’90s—were painfully stranded or misdirected when gas price forecasts shifted abruptly.
Predicting gas supply and demand is unlikely to get much easier. Abundant domestic gas could paradoxically exacerbate price volatility. One reason is trade. Unlike oil, bulk gas has been delivered almost entirely by regional pipelines, de-linking prices between the major markets in Asia, Europe, and the U.S. But huge new export facilities will abruptly send liquefied gas toward the best price, rippling supply adjustments across the global network. U.S. gas, for example, may veer to Japan, where gas fetches $16 because it’s still (for now) contractually linked to oil prices. Exporters would get a windfall; other Americans would pay higher gas prices. Since major shale gas reserves are not just in North America but also such places as China, Argentina, Mexico, Australia, and South Africa, easier global capital markets or faster national gas development could speed gas globalization, with all its benefits and travails.
Demand is no easier to predict. Finding gas in places previously “unpiped” will create additional thirst. So will competition in electricity, where gas took a tenth of coal’s market during 2005–10 (though nuclear prospects evaporated years before gas prices fell). Energy-intensive industries like petrochemicals and ammonia nimbly shift global marginal production toward cheaper gas. A trend to reward utilities for cutting customers’ bills, not selling them more gas and electricity, has spawned huge new efficiency industries; those plus new building codes in half the states are flattening electricity demand growth. Conversely, new markets are emerging: one major heavy truck maker expects 25% of its 2012 sales to burn natural gas. This tangle of savings, shifts, and substitutions further clouds the crystal ball.
Finally, add to these imponderable moving parts all of fracking’s technical, regulatory, and environmental uncertainties. Can we really believe we have irreversibly shifted to a “new normal” of low, stable gas prices, so this time will be different? The idea feels a little naïve.
To be clear, our argument is not to avoid the use of gas. We have substantial conventional gas reserves, and may be able to economically leverage a sustainable and environmentally responsible shale gas resource, too. But these resources should be developed prudently and used efficiently, counting gas’s full price including volatility. Doing or expecting otherwise risks enlarging the previous three misforecasts’ investment disasters.
And just as a financial portfolio manager balances yield and risk across different asset types, it’s important not to lose sight of the stable Treasuries in our energy portfolio. Energy efficiency and renewables eliminate fuel price risk. Efficiency opportunities abound worldwide wherever people and economic activity are (especially where growth is fastest, since it’s easier to build right than fix later). Efficiency has compelling economics today and an untapped potential far exceeding our newfound gas bounty. Renewables are similarly available in massive quantitities and increasingly at competitive cost, so starting in 2008 they’ve captured half the world’s market in new generating capacity. In 2011, non-hydro renewables won $225 billion of global private investment, added 84 billion watts of capacity, and invested their trillionth dollar since 2004.
We hope lingering uncertainties about shale gas will be satisfactorily resolved over the coming decade. If they are, we’ll enjoy more and cheaper gas than the futures market now believes, gaining optionality that cuts other energy risks. But if not, we won’t be unduly disappointed, because in the long run, America may not need all that extra gas anyway. Our team’s new study Reinventing Fire shows how we can harness business for profit to run a 2.6-fold bigger U.S. economy in 2050 with one-third less natural gas, no oil or coal or nuclear energy, and $5 trillion cheaper.
Now that’s an energy portfolio worthy of investment.