Chicago cheap gas prices

Why are U.S. natural gas prices currently at the high end? What are the implications of recent regulatory changes and changes in market fundamentals? This article explains the boom and bust nature of natural gas prices and some ways to reduce this volatility going forward.

Current natural gas prices in the U.S. are high-more than double their historical trend over the last five years-and futures prices indicate that natural gas supplies are likely to continue to be tight for at least the near term. High and volatile fuel prices are the consequence of both changing market fundamentals and regulatory decisions. Accordingly, the interplay of these effects could have substantial consequences, both nationwide and in the Midwest.1 This Chicago Fed Letter describes conditions that have put pressure on gas prices and suggests some potential strategies that might mitigate gas price volatility in the future.

Domestic market

Natural gas markets have been deregulated for the most part since the late 1970s, when the Federal Energy Regulatory Commission first allowed competitors to enter the natural gas pipeline industry. This deregulation movement broke the vertically integrated structure of the natural gas industry, which had arisen from federal interstate regulation dating back to early in the twentieth century. Deregulation opened up previously unrealized value creation opportunities that benefited most consumers and some producers. As a result, by the 1990s natural gas was widely available at very low prices, so low, in fact, that some producers went out of business or confined their extraction to existing deposits. Low prices reduce exploration, and high prices encourage it, resulting in a boom and bust cycle, which has historically been a feature of the industry.

Another development that has followed deregulation in the natural gas industry has been the creation of liquid, sophisticated financial markets for natural gas. The development of a wide range of financial instruments has enabled risk spreading in natural gas markets. The resulting ability to hedge risk across time and across different market conditions has substantially decreased the volatility in natural gas prices associated with the boom and bust cycle that characterizes extractive industries like natural gas.

So, why the recent spike in natural gas prices? The price increase has been fairly sudden, but not unpredictable. In fact, natural gas prices have been edging up since the late 1990s. Still, while the current and expected price increases are the consequence of the interaction of demand, supply, and other forces that shape the market, supply issues seem to be a particularly important factor.

Many analysts and energy industry experts have, correctly, pointed to regulatory restrictions as the prime cause of the rigidity of natural gas supply. In particular, they argue that limitations on drilling on federal lands, in consideration of the environmental amenities attached to those lands, have greatly limited exploration options. Approximately 40% of known natural gas reserves in the U.S. are off limits to exploration and production.

Another potentially abundant source of supply is imported liquefied natural gas (LNG) from such places as the Middle East, Russia, China, West Africa, and the countries around the Caspian Sea. However, the industry still has some work to do to convince the U.S. public that long-distance transportation of LNG is safe. And, even if the industry succeeds in this effort, it then has to build the necessary infrastructure to facilitate LNG imports onshore. LNG off-loading and storage at port requires specific technology in the terminals. Few such terminals exist in North America, and they take a long time to build. Construction of new LNG terminals can take up to a decade, taking into account siting and environmental regulatory processes. Accordingly, LNG terminal construction and imported supply is a long-term, though important, response to the current market imbalance.

Constrained supply is not the only cause of high natural gas prices. Environmental regulation of U.S. air pollutants was predicated on the assumption of abundant natural gas as a substitute fuel. Specifically, natural gas is a clean (and formerly cheap) fuel for electricity generation, particularly relative to bituminous coal. Improvements to existing power plants that have occurred in the past 30 years have overwhelmingly used natural gas to comply with the new source review regulations introduced in the early 1970s. And air quality regulations have led to a situation in which the only economical way to build new power plants is to fuel the facilities with natural gas. For example, 93% of new electricity generation capacity that will come online in the next two years will use natural gas to fuel generation.

This emphasis on natural gas as the way to achieve air quality improvements without dramatically increasing power generation costs has had the unforeseen consequence of reducing the resiliency of natural gas markets. Regulatory mandates have reduced our ability to apply the lessons of portfolio diversification to our energy choices. This is a very high price to attach to the environmental amenities of improved air quality, air quality that could conceivably have been achieved through other means if environmental regulations had not specified natural gas as the fuel input.

The potential implementation of the Kyoto Treaty exacerbates this costly balkanization of fuel portfolios. Even if the U.S. does not ratify the treaty, Canada's implementation of it would have a significant impact on the U.S. market as well. Canadian electricity generators would have to substitute into natural gas as they reduce their use of coal to meet the carbon dioxide reduction targets. If Canadian demand for natural gas increases to fuel its own power needs, then barring a substantial and unlikely increase in Canadian drilling and recovery, there will be much less Canadian natural gas available for export to the U.S. Most of our imported natural gas comes from Canada, both nationally and in the Midwest, so the dislocation to the U.S. natural gas market would be acute.2

Natural gas and the Midwest

At a June 26, 2003, conference sponsored by the U.S. Department of Energy, Secretary of Energy Spencer Abraham warned that tight natural gas supplies would translate into a 20% jump in home heating bills in the Midwest for the coming winter.3 This would mean that the average heating bill for the November through March "official heating season" would rise to $915. Even more worrisome is that such an estimate is based on normal weather conditions. A colder than normal winter would drive demand and prices even higher.

Since the Secretary's announcement, natural gas conditions have improved. The combination of increased drilling activity, mild summer weather, and some demand decreases and fuel switching by large industrial users have improved the supply balance, allowing for significant injections of natural gas into underground storage. By mid-July, estimates of working gas in storage stood at about 13% below the previous year.4 However, a return of warm weather could reverse this trend toward replenishing stocks if gas is needed for electricity generation. Similarly, gas prices as reflected by the futures contract on the New York Mercantile Exchange have fallen 25% since early June highs to around $5 per million Btus (British thermal units).

However, the Secretary's analysis points to one of the fundamental differences between the use of natural gas as a fuel in the Midwest versus the rest of the nation. While much of the gas supply problem during the summer has been blamed on the increasing use of natural gas to fuel electricity generation, in the Midwest, natural gas is disproportionately used for residential service and particularly home heating. As figure 1 (p. 1) demonstrates, per capita residential use of natural gas for the Seventh District is nearly twice the U.S. average. Thus, high gas prices will become particularly noticeable to Midwest consumers with the onset of winter. Also notable is the heavy usage of natural gas for industrial purposes in Indiana and Iowa. Many analysts have suggested that natural gas used for industrial purposes will be among the first to feel the effects of higher prices. Industrial customers are often more exposed to wholesale prices, and price spikes often lead to plants reducing activity or shutting down altogether. Industries such as aluminum, petrochemicals, plastics, and fertilizers are particularly vulnerable and, with the exception of aluminum, these industries do have a significant presence in the Midwest. As increasing natural gas prices raise production costs, some of these costs are likely to be reflected in the prices of fertilizers, chemicals, plastics, metals, and the products that use them as inputs, such as agricultural products.