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Posts Tagged ‘Natural Gas’

Will natural gas ever catch on as an important transportation fuel?

Yes, argues MIT Professor Christopher Knittel, in a new discussion paper for the Hamilton Project. Given the now-enormous spread between gasoline and natural gas prices, Knittel thinks that natural gas vehicles should become increasingly popular. Here, for example, are his calculations of the lifetime operating costs for various vehicles using gasoline or natural gas (click to enlarge, and be sure to read the caveat in the footnote): 

As you would expect, the biggest potential savings accrue to the most fuel-guzzling vehicles, heavy-duty trucks in particular.

Knittel does not believe, however, that the private market will exploit this potential as fast or extensively as it should. He thus proposes policies to accelerate refueling infrastructure build-out and to encourage natural gas vehicles. Here’s his abstract:

Technological advances in horizontal drilling deep underground have led to large-scale discoveries of natural gas reserves that are now economical to access. This, along with increases in oil prices, has fundamentally changed the relative price of oil and natural gas in the United States. As of December 2011, oil was trading at a 500 percent premium over natural gas. This ratio has a number of policy goals related to energy. Natural gas can replace oil in transportation through a number of channels. However, the field between natural gas as a transportation fuel and petroleum-based fuels is not level. Given this uneven playing field, left to its own devices, the market is unlikely to lead to an efficient mix of petroleum- and natural gas-based fuels. This paper presents a pair of policy proposals designed to increase the nation’s energy security, decrease the susceptibility of the U.S. economy to recessions caused by oil-price shocks, and reduce greenhouse gas emissions and other pollutants. First, I propose improving the natural gas fueling infrastructure in homes, at local distribution companies, and along long-haul trucking routes. Second, I offer steps to promote the use of natural gas vehicles and fuels.

His “steps to promote the use of natural gas vehicles and fuels” are subsidies and regulations. Regular readers will recall that I believe environmental taxes would be a better way of addressing environmental concerns and, in particular, of promoting natural gas over gasoline. Of course, that view hasn’t gained much traction among policymakers. As least not yet.

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The Congressional Budget Office is out with another fine infographic, this time on energy security.

The entire infographic is too big to post here, but here’s how Andrew Stocking and Maureen Costantino portray America’s energy sources and uses:

One of the most notable features is the absence of any link from natural gas to transportation (some natural gas is used in transportation, of course, but not enough to make the cut for this image). Given the ever-growing divergence between oil and natural gas prices, I wonder whether that will still be true a decade from now? Or will someone finally crack the natural gas to transportation fuel market in a big way?

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Over at Bloomberg, Julie Johnsson and Mark Chediak document how low natural gas prices are reshaping electricity markets. Wind, nuclear, and coal all look expensive compared to natural gas generation:

 With abundant new supplies of gas making it the cheapest option for new power generation, the largest U.S. wind-energy producer, NextEra Energy Inc. (NEE), has shelved plans for new U.S. wind projects next year and Exelon Corp. (EXC) called off plans to expand two nuclear plants. Michigan utility CMS Energy Corp. (CMS) canceled a $2 billion coal plant after deciding it wasn’t financially viable in a time of “low natural-gas prices linked to expanded shale-gas supplies,” according to a company statement.

Mirroring the gas market, wholesale electricity prices have dropped more than 50 percent on average since 2008, and about 10 percent during the fourth quarter of 2011, according to a Jan. 11 research report by Aneesh Prabhu, a New York-based credit analyst with Standard & Poor’s Financial Services LLC. Prices in the west hub of PJM Interconnection LLC, the largest wholesale market in the U.S., declined to about $39 per megawatt hour by December 2011 from $87 in the first quarter of 2008.

Power producers’ profits are deflated by cheap gas because electricity pricing historically has been linked to the gas market. As profit margins shrink from falling prices, more generators are expected to postpone or abandon coal, nuclear and wind projects, decisions that may slow the shift to cleaner forms of energy and shape the industry for decades to come, Mark Pruitt, a Chicago-based independent industry consultant, said in a telephone interview.

The hard question, of course, is whether low natural gas prices will persist, particularly if everyone decides to rush into gas-fired generation:

“The way to make $4 gas $8 gas is for everyone to go out and build combined-cycle natural-gas plants,” Michael Morris, non-executive chairman of American Electric Power (AEP) Inc., said at an industry conference in November. “We need to be cautious about how we go about this.”

The whole article is worth a read if you follow these issues. (ht: Jack B.)

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In 2010, I wrote a series of posts documenting how oil and natural prices had decoupled from each other (see here and here). For many years, oil prices (as measured in $ per barrel) were typically 6 to 12 times natural gas prices (as measured in $ per MMBtu). That ratio blew out to around 20 in 2009 and again in 2010, a severe break with historical trends.

At the time, that seemed like an enormous disparity between the two prices. In retrospect, we hadn’t seem anything yet. As of yesterday, the ratio stood at more than 33:

A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would thus tend to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline means that oil is more valuable. So oil has usually traded higher.

But the current ratio is unprecedented. Each Btu of oil is now worth about five times as much as each Btu of natural gas. Thanks to a torrent of new supply, natural gas prices are down at $3.00 per MMBtu even as oil (as measured by the WTI price) has risen back above the $100 per barrel mark.

Perhaps natural gas vehicles will be the wave of the future?

Note: Energy price aficionados will note that I’ve used the WTI price in these calculations. That used to be straightforward and unobjectionable. Now, however, we have to worry about another pricing discrepancy: WTI is very cheap relative to similar grades of oil on the world market (for background, see this post). For example, Brent crude closed Monday around $112 per barrel, well above the $101 WTI price. Brent prices are relevant to many U.S. oil consumers. There’s a good argument, therefore, that my chart understates how much the price ratio has moved. 

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In a series of posts (most recent here), I’ve noted that oil and natural gas prices have become unhinged from each other. Oil (denominated in $ per barrel) used to trade at 6 to 12 times the price of natural gas (denominated in $ per MMBtu). But lately that ratio has been north of 20, thanks to a surfeit of new gas in the United States (and elsewhere) and, recently, growing global demand for oil.

The wide spread between oil and natural gas prices provides a tempting incentive for any innovators who can figure out how to use natural gas, rather than oil, to make transportation fuels.

Over at the New York Times, Matthew Wald identifies one possibility, using natural gas to produce diesel:

Diesel and jet fuel are usually made from crude oil. But with oil prices rising even as a glut of natural gas keeps prices for that fuel extraordinarily cheap, a bit of expensive alchemy is suddenly starting to look financially appealing: turning natural gas into liquid fuels.

A South African firm, Sasol, announced Monday that it would spend just over 1 billion Canadian dollars to buy a half-interest in a Canadian shale gas field, so it can explore turning natural gas into diesel and other liquids. Sasol’s proprietary conversion technology was developed decades ago to help the apartheid government of South Africa survive an international oil embargo, and it is a refinement of the ones used by the Germans to make fuel for the Wehrmacht during World War II.

The technology takes “a lot of money and a lot of effort,” said Michael E. Webber, associate director of the Center for International Energy Environmental Policy at the University of Texas, Austin. “You wouldn’t do this if you could find easy oil,” he said.

But with the huge spread between oil and gas prices, and predictions of oil topping $100 a barrel next year, the conversion technology could be a “a money-maker for whoever is a first mover in that space.”

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In previous posts (most recent here), I noted that oil and natural gas prices have disconnected from their usual historical relationship. For many years, oil prices (as measured in $ per barrel) tended to be 6 to 12 times natural gas prices (as measured in $ per MMBtu). That ratio blew out to more than 20 in late 2009, briefly receded toward more traditional levels, and then expanded again. At Tuesday’s close, the ratio stood at 19.4, far above its historical range:

(Note: A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would thus tend to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded higher.)

The unusual pricing of the last two years reflects two factors. First, there has been a dramatic–and welcome–expansion in domestic natural gas supplies. That’s driven natural gas prices down to less than $4 per MMBtu at yesterday’s close. Second, there is limited opportunity for energy users–utilities, businesses, and homeowners–to switch from oil to natural gas. Years ago, such switching linked oil and natural gas prices relatively closely. But today those prices appear largely decoupled.

All of which poses an important question for investors, forecasters, and industry planners: Will historical relationships eventually reassert themselves, perhaps by longer-term fuel switching by utilities and transportation fleets to natural gas? Or is this time really different, with old pricing relationships no longer relevant?

One way to answer that question–or, at least, to get some insight into how others are answering it–is to look at futures prices. As illustrated in dark blue above, those prices imply that the ratio of oil to natural gas prices will remain well above historical levels for at least the next eight years. The new normal, according to futures markets, will be for oil prices to average about 15 times natural gas prices.

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My recent post about oil and natural gas prices elicited some very constructive responses from readers (thanks in particular to PJ, MF, and FW, in addition to public commenters on the post). As a result, I’ve rethought my discussion of the relationship between oil and natural gas prices.

I was also inspired to look at the futures markets to see what they are signaling about the relationship between oil and natural gas prices. Here’s my usual chart of the ratio of oil prices to natural gas prices, now showing both history (lighter blue) and futures markets (darker blue):

As noted in my earlier posts, oil and natural prices appear to have disconnected from their historical relationship. For many years, oil prices (as measured in $ per barrel) tended to be 6 to 12 times natural gas prices (as measured in $ per MMBtu). That ratio blew out to more than 20 in late 2009, then receded to more traditional levels, and then blew out again in recent months. At yesterday’s close, the ratio stood at 21.8, far above its historical range.

In my previous posts, I argued that this unusual pricing reflects the sudden (and welcome) increase in natural gas supplies and that we should expect oil and natural gas prices to eventually move back toward their historical relationship as markets absorb the new gas. Of course, I was careful not to say when this would happen.

As shown in the graph, the futures markets are indeed signaling some normalization in the price ratio in coming years, but not a rapid one. Moreover, even after eight years, the ratio would return only to the upper end (12) of its historical range. (Caveat: Futures markets are quite thin that far out, so we shouldn’t place too much weight on those distant prices.)

Let me offer a revised interpretation of the pricing relationship that’s consistent both with the futures data and the comments I received. This interpretation (consider it a theory, really) distinguishes four time periods:

  • Good Old Days: For many years, the electric utility industry had generating plants that ran on oil, natural gas, or both. The ability to fuel switch (either by changing the dispatch order of oil and gas plants or changing fuels at plants that could use either) limited how much oil and natural gas prices could deviate. If oil prices fell too low, utilities would move from natural gas to oil, and vice-versa. Similar fuel arbitrage occurred, to varying degrees, among other uses as well (e.g., home heating and some industrial uses).
  • More Recent Days: In recent decades, electric utilities have embraced natural gas and moved away from oil. As a result, there is much less opportunity for arbitrage between the fuels. The same has happened among other fuel consumers as well. Oil and natural gas prices nonetheless remained within their usual historical relationship. For example, oil and natural gas prices rose and fell in tandem during 2008. This suggests that the markets encountered similar shocks during those years (e.g., strong demand or, some would argue, speculation), not that they were linked via arbitrage.
  • Today: With the decline of traditional fuel arbitrage possibilities, oil and natural gas prices can now move separately if they experience distinct shocks. That appears to have happened with the increase in natural gas supply, for example.
  • Future: Looking further ahead, however, one would expect some new arbitrage relationships to develop. If we have persistently cheap natural gas and persistently expensive oil, that creates an incentive for ingenious folks to find ways to use natural gas to serve what have traditionally been oil demands. That should eventually limit the degree to which the prices can deviate (although not necessarily in the 6 to 12 ratio range). Two leading candidates for this linkage are using natural gas as a transportation fuel (directly as a fuel and perhaps indirectly as electricity) and increased international trade in liquified natural gas.

Note: The chart uses the spot price for West Texas Intermediate at Cushing and the spot price for natural gas at Henry Hub on a monthly basis through March 2010. For April 2010, I use the closing prices on April 8. The monthly futures are from the CME Group.

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Update (4/9/10): Please see my follow-up post as well.

Last summer I noted that oil and natural gas prices had diverged to an unprecedented degree. I bravely predicted that this divergence would reverse (unbravely, I didn’t predict when).

As the chart below shows, I was right: the price relationship did move sharply toward normal levels. In the last two months, however, it’s blown out again:

The chart shows the ratio of the price of oil (measured in $ per barrel) to the price of natural gas (in $ per MMBtu). Under normal circumstances, that ratio fluctuates between 6 and 12. A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would thus tend to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded higher.

Natural gas closed today at $4.11 per MMBtu. Under normal circumstances, that would imply an oil price of around $25 to $50. But oil actually closed above $85. As a result, the ratio of oil prices to natural gas prices is up at 20.7, well above the usual range and closing in on the peaks of last summer (on the day before I wrote my earlier piece, the ratio reached 24.5).

Where do prices go from here?

Well, history still suggests that the price gap will eventually narrow, through some combination of oil prices falling and natural gas prices rising. But there’s no guarantee that will happen in the short-run. Over the longer-term, however, I feel confident that demand for natural gas will rise to meet the new supply (the prime reason why natural gas prices have been so low recently) and that the oil vs. natural gas price relationship will eventually move back to normal. Natural gas is cleaner than coal and is available in large quantities in the U.S. and Canada. As a result, natural gas is on the short-list of potential responses to climate change and oil dependence, two concerns that aren’t going away anytime soon.

Note: The chart uses the spot price for West Texas Intermediate at Cushing and the spot price for natural gas at Henry Hub. Both series are monthly, except for the prices for today, 4/01/10.

P.S. Note that I have again obeyed the first law of forecasting: I have given a prediction (the relationship between oil and natural gas prices will normalize), but I haven’t given a date.

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A couple weeks ago, I discussed the remarkable divergence between the prices of oil and natural gas. At the time, the spot price of West Texas Intermediate was above $73 per barrel, while the spot price of natural gas at the Henry Hub was about $3 per MMBtu. The ratio of the two prices was at record levels, with the oil price 24.5 times the natural gas price.

Oil prices have declined since then, closing at $68.24 per barrel yesterday. But natural gas prices have also declined, closing at $2.82. As a result, the price ratio remains above 24, much higher than the 6 to 12 that’s been normal in recent decades.

To provide some more insight into what’s going on, I made a new graph to show the path of oil and natural gas prices since the start of 2001:

Natural Gas and Oil Prices - Sep 1 2009

The chart (squiggle, if you prefer) tracks the path of monthly average oil prices along the horizontal axis and monthly average natural gas prices along the vertical, plus yesterday’s closing data. Several features of the graph leap out:

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Yesterday marked a new record in the divergence between oil and natural gas prices.

As noted in a small item in the Wall Street Journal, the ratio of oil prices ($ per barrel) to natural gas prices ($ per million BTU) hit a record 24.5 at yesterday’s close. As you can see from the following chart, that’s far out of line with historical norms:

Ratio of Oil to NG (August 21 2009)

A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would tend to to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded between 6 and 12 times the price of natural gas.

That’s changed in recent months. Natural gas prices have fallen to $3.00 per MMBtu, weighed down by new supply and weak demand. Oil prices, however, have stubbornly increased to more than $70 per barrel. That’s down sharply from the $100+ prices of last year, but up sharply from the $40 – $50 range earlier this year.

Where do prices go from here?

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