Highlights

  1. Due to natural gas’ seasonal demand profile, weather and storage play significant roles in setting short-term natural gas prices.
  2. Combined with commodity cycles, these factors can enable natural gas prices to be exceptionally volatile.
  3. This volatility expresses itself in electricity markets through coal to natural gas displacement and electricity prices.
  4. The nature and severity of natural gas volatility could change in the future as shale production grows, overall demand grows, LNG exports increase, and renewable energy impacts seasonal demand.

Natural Gas Demand Profile Creates Volatility

Price volatility is probably the most important economic characteristic of natural gas. As natural gas becomes the dominant electricity source in the United States, its price volatility will increasingly impact electricity markets.

Like other commodities, natural gas prices are determined by supply and demand. Natural gas is unique among energy sources because it has multiple primary end uses: electricity, heat, feedstock, and even some transportation. Total demand varies seasonally while supply is usually flat; the costs of storage cause volatility and price changes balance this temporal mismatch

Since 2009, the natural gas supply has changed significantly as a result of the shale revolution; new technologies and resource locations have drastically reduced the cost of extracting natural gas. This led to much lower natural gas prices than in the early 2000’s.

However, supply costs are only part of the equation to determine price. Demand matters as well. Unlike other fuels, natural gas demand is highly seasonal and can vary significantly year to year based on winter weather. In order to guarantee enough storage for the subsequent winter, natural gas prices change greatly year to year.

This article explores the cause of natural gas price volatility, describes it impacts on electricity markets, and concludes with a critical observation: several factors could greatly change the nature of natural gas price volatility in the next five years.

Winter Weather is Primary Factor Driving Short-Term Natural Gas Volatility

There are two primary drivers of price volatility that closely interact: variability in weather-driven natural gas demand and variations in available supply due to commodity cycles. Of the two, weather-driven demand can have some of the more dramatic and visible impacts on natural gas prices.

Natural gas is unique among energy sources because it is used in multiple sectors. According to the EIA, natural gas consumption in 2015 was split between:

  • Electric power (35.1%)
  • Industrial Use (27.3%)
  • Commercial (11.7%)
  • Residential (16.9%)
  • All other (9.0%)

Critically, most commercial and residential demand is for heating, which occurs almost entirely in winter. Therefore natural gas demand has a highly seasonal demand profile.

Monthly Natural Gas Demand by Sector, Average of 2011-2015

Natural gas demand profile is highly seasonal due to heating demand for residential and commercial sectors

Source: SparkLibrary, based on data from EIA

Over the last five years, January natural gas consumption averaged 96.0 Bcf/day. This is 31-38 Bcf/day (47-65%) higher than average consumption during non-winter months.

Conversely, natural gas production does not have major seasonal patterns and is relatively flat over the course of the year.

In order to match these seasonal differences between production and storage, natural gas heavily relies upon storage. The U.S. has a total underground natural gas storage capacity of 4,343 Bcf at 385 facilities in the U.S., although it never quite approaches full capacity.

Storing natural gas is relatively expensive, so storage usually occurs on one annual cycle: injection season usually lasts from early Spring to mid-November, while withdrawal season lasts from mid-November to early Spring. Multi-year natural gas storage is rare.

As anyone knows, winter weather can vary considerably, with subsequent effects on natural gas storage.

  • A warmer winter reduces natural gas demand, leading to higher storage levels and lower natural gas prices (to incentivize demand before the next winter).
  • A colder winter increases natural gas demand, reducing storage levels and increasing natural gas prices (to reduce demand to ensure sufficient storage for next winter).

Henry Hub Spot Natural Gas Price, with Severity of Winter Weather Noted, 2011 to mid-2016Natural gas prices are shaped by the severity of the previous winter weather

Source: SparkLibrary, based on data from EIA

During the last five years, we have seen both extremes: the winters of 2011-2012 and 2015-2016 were both exceptionally warm, reducing natural gas demand. Subsequently, natural gas prices declined over the course of both winters and reached decadal lows below $2/MMBtu in spring.

Conversely, the winters of 2013-2014 and 2014-2015 were both very cold. During the 2013-2014 winter, heating demand was so high that it drove natural gas storage down to only 800 Bcf, less than 20% of capacity and a level not seen in at least ten years. Prices quickly rose and, from a range a $3-4/MMBtu in 2013, were above $4/MMBtu for most of 2014.

Commodity Cycle Also Influences Price Volatility

Natural gas prices influence production decisions, meaning that weather indirectly influences production through prices. In 2014, prices above $4/MMBtu set the stage for a massive supply response – these were the highest prices in several years.

Critically, shale technology had advanced significantly since prices were last that high in 2012. Although renewable energy’s technological development is often emphasized, shale technology is relatively young and the technology is still being developed.

In the last several years, natural gas producers have been able to drastically increase natural gas production from shale wells by: increasing wells per drill pad, reducing labor costs through automation, and perfecting many other fracking techniques.

Improving production per rig led to dramatic declines in rig counts nationally, partially indicating cheaper production costs.

Natural gas production per rig has increased significantly in the Marcellus even as rig counts collapsed

Source: EIA

Shale natural gas now dominates US natural gas production.

It also has a key technical characteristic that makes it well suited to addressing short term price increases: its production peaks more rapidly and declines more quickly than conventional natural gas wells. The majority of a well’s production comes in the first 18-24 months, with 80% or more occurring in the first five years.

When prices rise, natural gas producers can thus lock in prices for most of a well’s production. Over time, the ‘long tails’ of production from older wells form a growing base of natural gas production. Refracking old wells where production has tapered off could potential increase production from older wells at a low cost, but remains in early stages.

The below two charts for shale oil conceptually illustrate well decline rates and net effects of production long tails on overall  natural gas production.

Shale oil production in Eagle Ford Drops off rapidly in first six months

Source: EIA

Long tails from past shale oil wells provide strong base for continued production growth

Source: EIA

When cold weather drove prices higher in early 2014, new shale developments enabled a boom in natural gas production. Between December 2014 and December 2015, US natural gas production increased by almost 6 Bcf/day or 10%.

Thus, while cold weather kept demand high in winter 2014-2015, natural gas prices began to decline over the course of the winter. From more than $4/MMBtu at the start of the winter, prices neared $2/MMBtu within twelve months.

These types of cyclical supply-and-price fluctuations are common in commodity markets where storage costs are high. They happen as a direct result of supply and prices affecting each other:

  1. When prices are high, there is an incentive to bring more supply online
  2. More supply leads to lower prices
  3. Lower prices lead to a decrease in supply
  4. Decreased supply drives prices higher
  5. Repeat

Commodity cycles can happen on both longer and shorter timeframes. Oil provides a good example of a longer term cycle: very high oil prices from the mid-2000’s to mid 2010’s provided a significant incentive to increase global oil production. Resources that were previously uneconomic, such as deepwater drilling or tar sands, were profitable at $100/barrel, leading to large increases in supply. Subsequently, the addition of these resources and breakthroughs in shale technology led to oversupply and prices to collapse.

Power Sector is Primary Short Term Balancing Mechanism

When winter weather causes a shift in the natural gas supply-demand balance, higher prices can cause increased supply. However, even with shale, it can take 9-12 months before higher prices drive material increases in production.

In light of this time lag, the only way to ensure sufficient storage for winter (or prevent storage overflow) is by adjusting short-term natural gas demand.

As noted before, natural gas is unique as it is consumed in multiple sectors. Critically, demand in the residential, commercial, and industrial sectors is relatively price inelastic, especially in winter:

  • Homes and business will continue to use natural gas to heat their homes in the winter regardless of how cold it is.
  • Most natural gas consumers purchase from regulated utilities at prescribed rates, further limiting a demand reaction to high prices.

Effectively, these three sectors are not price sensitive in the short term at the prevailing prices of the last several years.

Thus, the major area where natural gas demand can adjust upwards or downwards in the short term is in the power sector.

Before the shale revolution, the United States built a significant fleet of natural units. This fleet was relatively unused until shale production started reducing natural gas prices. With the capacity in place, lower prices can lead to increased generation from the existing natural gas fleet relatively easily and quickly.

Year-Over-Year Changes in U.S. Power Sector Natural Gas Demand and Overall Dry Production

Natural gas demand follows weather and prices while supply increases or stays flat depending on prices

Source: SparkLibrary, based on data from EIA

Wholesale Power Prices Reflect Coal and Natural Gas Competition

As we’ve discussed before, the cost structures of energy sources determine how they impact power markets. Solar, wind, hydro, and nuclear power are all capital intensive with low marginal costs. According, these units are almost always dispatched when they are able.

Coal and natural gas have high marginal costs that vary along with fuel prices, making them primary competitors for marginal electricity generation. As they are the primary marginal fuel sources in both rate-regulated and restructured wholesale power markets, coal or natural gas usually sets the market clearing price.

Therefore, in order to balance short natural gas demand to meet storage needs, natural gas prices change to the degree necessary to induce a shift in gas-coal competition in via higher or lower  electricity prices.

If natural gas power sector demand needs to go down:

  1. Natural gas prices go up
  2. Increasing dispatch costs at natural gas facilities
  3. Raising wholesale electricity prices until…
  4. Coal generation is more competitive and increases, displacing less competitive natural gas units and reducing gas demand.

For a simple example, imagine a relatively inefficient combined cycle is competing with a coal generator. At $4/MMBtu, the natural gas combined cycle would have a dispatch cost of around $40/MWh. Say the coal generator has a dispatch cost of $43/MWh. In order to decrease natural gas demand, natural gas prices would have to increase until the dispatch cost for the coal generator is lower. In this case, natural gas prices would have to increase more than $0.30/MMBtu to drive dispatch costs higher than $43/MWh.

If natural gas demand needs to increase (due to relative short term oversupply), the opposite happens, with natural gas prices going down until natural gas replaces coal through power market competition. Note that coal prices will also change as power sector coal demand decreases or increases; this is the major reason why coal prices approximately track natural gas prices.

Effectively this short-term coal versus gas competition is a primary driver of prevailing wholesale electricity prices. In the short term (hourly, daily, or weekly), there is very limited competition between natural gas and non-coal power sources (particularly for renewables with their long-term fixed contracts).

Future of Natural Gas Price Volatility Uncertain

As natural gas demand continues to grow in the power sector and elsewhere, natural gas price volatility will become an even more important feature of U.S. energy markets. Understanding future changes in the severity and frequency of natural gas price volatility is thus critical to understand how to craft policy and market design for a shale-dominated world.

Recent developments in US electricity markets, resulting from the shift from natural gas to coal, may change the short term nature of price balancing:

  • A significant number of thermal power plants have converted from coal to using natural gas, with relatively inefficient heat rates
  • The most inefficient coal plants retired due to economic competition with natural gas and other coal sources or due to environmental retrofit requirements
  • The remaining coal fleet is likely in a death spiral. As capacity continues to decline, potential NG-coal displacement decreases as does the cost for displacement.

All else equal, this likely means that the range for natural gas prices is likely to be $2-4/MMBtu for the next several years, as compared to about $2.50-5/MMBtu pre-MATS. However, if price sensitive power sector demand is insufficient to balance natural gas markets (due to limited coal left to displace), prices could be periodically more volatile.

More broadly, the US natural gas market is in a state of rapid development and transition. Several major developments will shape the future nature of natural gas price volatility:

  • Continuing general increases in overall natural gas demand and supply will increase the size of the market; relative storage capacity may or may not keep pace
  • Climate change induced changes in summer and winter weather severity (likely already evident in recent prices) will change required storage levels, storage drawdown, and may elevate short term volatility
  • US international trade in natural gas is poised to rise, with Mexican exports already increasing and LNG exports beginning
  • Rapid development of renewable energy may alter NG versus coal competition by limiting dispatchable demand for many hours of the year, particularly in shoulder seasons

Each of these factors individually could dramatically alter the severity and frequency of natural gas price volatility. For example, all else equal, the decline in coal generation could cause more severe price spikes during extreme weather events due to a lack of cheap, alternative short term demand destruction.

Together, however, the net effect is exceptionally difficult to determine. In particular, climate change induced changes in the weather-driven demand profile of natural gas may reduce overall storage requirements, leading to lower volatility. In February 2017, very warm winter weather led to the first net weekly injection of February, a highly unusual development.

What is clear though, is that natural gas’ growing role in US energy makes its volatility a key factor to understand and manage moving forward.

Read more:

  1. Natural gas’ price volatility makes it a natural complement to fixed costs renewables: https://www.sparklibrary.com/the-case-for-natural-gas-and-renewable-energy/
  2. This EIA analysis is pre-shale but provides a good overview of NG volatility drivers plus a look at historical price volatility: https://www.eia.gov/pub/oil_gas/natural_gas/feature_articles/2007/ngprivolatility/ngprivolatility.pdf