August 23, 2012

The Trend in Natural Gas Prices

I used to mull around the idea of changing my home furnace from electric to natural gas.   But then for several years gas prices kept going up and up while electricity wasn't increasing much at all.   I projected that trend into the future a few years and saw that it wouldn't take long before gas was not cheap enough to warrant a new furnace.   I mean if gas is 1/2 the cost of electricity today thats great but if gas doubles in price in 5 years then I wouldn't have saved much.   The price of natural gas has turned around in the past couple years.  Whether or not I should switch to natural gas to heat my home or power our appliances would depend on the future natural gas trends.   Given that, I should have some idea on the recent history and forecasted future of the price of natural gas.

Last year I wrote an article about the history of natural gas prices from 1967 to 2010.   You can see the trend there.   You can also look at the annual residential prices from EIA with latest data and you can see residential gas prices were going up steeply from 2000 to 2008.   In fact from 1999 to 2006 the price doubled which equates to 10% compound annual growth.  But also you can see there that prices have dropped about 20-25% for residential customer in the past 3 years or so.

Those were residential prices.   EIA has wellhead prices too which are at the producer side.  Well head prices have dropped in half in the past year.  In May 2011 it was $4.12 per 1000 cubic ft and by May 2012 it was down to 1.94.

There is of course a relationship between wellhead prices and residential prices but they don't move in lock step and change the same % at the same time.   Residential prices include fixed overhead costs and other factors that don't change based on the raw wellhead gas price.   Plus generally utilities don't and often can't simply raise or drop prices day to day.  The utility rates are often regulated by state agencies that have to approve price changes. We will probably see further residential price decreases as wellhead prices drop but its not going to be cut in half like the wellhead prices.

OK so natural gas prices were going up steeply for year over year for around a decade and then in the past few years they started dropping.   Does this mean its a good idea to run out and buy a gas furnace?    There isn't going to be any solid answer to this because I can't tell the future.    But we could get a better idea on what natural gas prices might do by getting a better idea of why they are dropping. 

First, why did natural gas prices start dropping?    I would have guessed that it was simply due to the recession and market forces caused lower demand and prices dropped due to it.   However it appears theres a bigger non-cyclical reason gas prices have dropped.    The website article Natural Gas Goes Down in Flames says for the price increase "You can blame the new “fracking” technology, which in the last four years has unlocked a 100 year supply of natural gas in shale fields,...".    A doubling in supply availability would have a huge impact on prices and it seems clear that this is the key reason prices have dropped.    In addition to that, a Businessweek article points out that oil drilling produces natural gas as a byproduct so higher oil prices cause more oil drilling and also increases natural gas production.   Now that is more of a cyclical impact but it only worsens the current drop in natural gas.

Given that gas prices have gone down due to increased supply, whats that tell us about the future of the prices?   There is a pretty big glut in production right now and the producers are trying to cut production to decrease supply and hopefully see their prices stabilize or go back up.   That Business week article also mentions how at current prices its hard for the gas producers to be profitable so I think we've likely hit a floor in prices.   Further the article also says : "There is probably a second 100 year supply out there, but with prices so low, what is the point in looking."    However I don't know how much truth there is to that idea, though its something to consider.

The amount of natural gas available on the supply side will impact prices.   The actual amount we can get is unknown.  There are estimates but they aren't perfect.   On one hand I find an article on Reason that suggests we could have 250 years worth of natural gas around the world and on the other hand Slate questions the 100 years worth currently estimated is accurate.   Its possible we could find ways to get even more natural gas in the future.    On the other hand its also possible that regulations could limit fracking and restrict the supply.   There is already a lot of talk about negative impacts from fracking.   I haven't followed that myself but its easy to see how public perception and legislation could limit an energy source, just look at nuclear energy in the U.S.  

I think you could make a reasonable prediction about the short term trend for natural gas prices.   Currently theres a glut of supply and prices have been trending down sharply.  It seems likely that prices will bottom before too long when the price hits the point that production costs make it unprofitable to produce gas.  It look like prices are likely to go up significantly in the short term for the next few years.   After that, the longer term future in 5 years or more is anyones guess as far as I'm concerned.   There are a lot of variables and unknowns that could cause natural gas to change in price in the long term.

My opinion is that natural gas will drop a bit and then stabilize over the next few years.   I wouldn't even attempt a guess on the price trend in the longer term.

Back to the original topic of switching my home furnace to natural gas..   For the short term I don't expect large increases in natural gas prices.   Therefore I could look at the current natural gas prices for my predictions on the return on investment in a conversion to natural gas for my heating.   However I have no idea on the longer term price trends for natural gas and this unknown is something I should consider when evaluating the financial return of a conversion to natural gas.
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