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karlwmiller (< 20)

Why the U.S. Natural Gas Industry is NOT in a State of Permanent Excess Supply

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December 30, 2009 – Comments (1) | RELATED TICKERS: CHK , DVN , EOG

December 29, 2009--Karl W. Miller a senior energy executive and institutional investor today issued the following statement through his advisors, regarding the statements made today by a purported energy industry analyst on CNBC (http://www.cnbc.com/id/34621936 ) that the U.S. Natural Gas Industry is in a state of "permanent excess". Mr. Miller believes that this statement was grossly irresponsible, not accurate, and has no merit whatsoever.

Mr. Miller is a strong proponent of natural gas and called the revival of natural gas earlier this year (http://www.investorideas.com/news/122909a.asp), but the gross inaccuracies being portrayed about Natural gas production, supply, and end use in Washington and select media require immediate correction for the benefit of public interest.

Natural gas is utilized by three major class of consumers; i) the power generation industry; ii) the industrial complex; iii) the local utilities across the U.S. which distribute natural gas to individual homes and office buildings.

As Mr. Miller details in review of the “Dash to Natural Gas” of the 1990’s through 2005, a tremendous amount of natural gas fired power plants were constructed, some in “load centers” or major consumption areas, some in fringe areas like the southeast U.S. and some in outright poor locations. To put the rationale to construct all of these natural gas fired power plants in layman terms, these natural gas fired power plants were supposed to replace the older coal fired power plants controlled by the regulated utilities across the country, be more efficient, and emit much less CO2.

The industry forecast and thesis at that time was for natural gas to be priced at $3.50/$4.00/mmbtu in perpetuity, as natural gas was in oversupply, plentiful and would never in theory be interrupted, thus always available for firm delivery.
The plants were built on a scale never seen before in U.S. History, over $500 billion of debt was added to the top 80 utilities and natural gas companies going into 2001, and the independent natural gas power plant market promptly crashed, went into financial distress and faded away from the mainstream.

The regulated utilities would not close the older, less efficient, and larger carbon emitting coal plants, nuclear stranded cost were winding down and the owners of nuclear power plants had substantially reduced amortized cost basis, thus could sell their power cheaper than natural gas plants, and the U.S. never implemented a national energy plan, and natural gas was not always available in certain regions during peak demand.

These natural gas power plants are still on the ground, some running, some mothballed. If natural gas were truly “in permanent excess supply”, the utilities would immediately shut down hundreds of the coal plants running 24 hours a day across the country, fire up the natural gas plants under their control, and contract with the independent power producers who control the other natural gas plants across the country.  This has not happened during the past ten (10) years, nor will it happen anytime in the foreseeable future.

It is very positive that independent gas producers have started to discover and exploit alternative means of extracting natural gas from within the U.S. borders, as Mr. Miller firmly believes and has advised Washington and the industry that it will become a “bridge” fuel by default. Despite the fact that Washington simply does not have the energy market knowledge or capacity to implement a credible energy plan for the U.S.

The hope of a bi-partisan energy plan has escaped the current administration, despite continued counseling from Mr. Miller and many other senior energy executives.  However, this does not mean that natural gas is overflowing out of every gas valve across the United States. Nor will it for quite some time.

By far, the largest consumer of natural gas should be the power generation industry across the U.S. If CO2 limits are put in place by the Federal Government at some point in the future, or individual states through the imposition of CO2 non-attainment zones, displacing and disadvantaging coal fueled plants, and all or a large portion of the natural gas power plants on the ground today were to be run as base load (running 24 hours a day) plants, excluding the small gas peakers, a tremendous strain would be put on the natural gas distribution system (major pipelines and local distribution pipelines) and diminishing any “purported permanent excess supply.

Secondly, if the local utilities started pulling gas at higher rates through the City Gate (delivery points for natural gas to major retail consuming areas like Chicago, for example), due to retail consumers using a greater amount of natural gas, a further strain would be put on the distribution system, in addition to further diminishing any “purported permanent excess supply”.

Thirdly, if the U.S. industrial complex started pulling more natural gas into their industrial facilities (the Texas/Louisiana petrochemical/refinery complex for example) a further strain would be put on the distribution system, in addition to further diminishing any “purported permanent excess supply”.

Fourthly, if we start fueling truck fleets, automobiles, and other transportation vehicles with natural gas, the question must be asked, is supply sufficient at peak heating market demand time of the winter months and peak cooling season of the summer? Is the transmission and distribution system in place to handle such use of natural gas that we can say with authority that “natural gas is in permanent excess supply”?

Also, do we have the necessary “high deliverability gas storage facilities” (salt dome or depleted fields) to handle these large withdrawals and swings of natural gas to meet excessive demand, which would essentially break the current seasonal injection period during the summer months and withdrawals during the winter months?

There would be no injection season as the industry knows it today, and no historical statistics to use as a benchmark, thus prices would continue to be volatile, reflecting a more real time supply/demand ratio for physical natural gas and for future delivery (futures contract), which they should.

Those that can pay for the physical resource in real time would set the price of natural gas, and Mr. Miller is firmly convicted this will lead to higher prices and volatility, rather than lower prices and volatility. This is what is commonly referred to as a “free market”.
 
Take for example the construction of a wind park in the desert of Arizona or Nevada for example, without a transmission line to deliver any electricity produced to the end user. The wind park owner could say that he has excess power supply; however, he has no means of transmitting that power supply to an end user, rendering the wind power useless.

Finally, if natural gas were in “permanent excess supply” there would be no independent natural gas producers in business such as XTO (Exxon), EOG, DVN, CHK, APC, and many other independent producers critical to the future of the U.S. Energy industry and overall economy.

Also, signing long term contracts with end users to lock in a percentage of natural gas production is a long standing practice in the industry; alternatively locking in the price the natural gas producer receives through a long term natural gas swap.

These are a positive event for the industry, as long term contracts allow producers to gain financing of their production operations, not a negative sign or downward price signal. In fact, history has shown that the higher percentage of long term contracts put in place, the scarcity of supply principle takes over, and prices become more volatile and sensitive to supply/demand events, given a larger portion of the commodity is locked up and a smaller portion is available for the spot market or for future delivery. Thus prices rise.
 
There was a time in the 1980's when independent natural gas producers could not even get financing to produce the gas in the ground that they owned under conventional drilling and recovery methods, that's why we as an industry invented the gas bank deal structure, to help finance these producers and bring natural gas to market. We opened up the natural gas pipelines, deregulated the industry and created “open access”, thus a free market.

If the U.S. were awash in natural gas, we would shut down the coal industry, stop building wind farms and solar farms, and there would be no need for a comprehensive energy plan for the U.S. to gain energy independence.  We would simply flat-line natural gas prices.

This will not happen anytime in the near future. Natural gas is a fuel of the future, but price volatility will rise, not fall and this is not a bad thing. It is a sign of a healthy, vibrant, and credible asset class, “natural gas

1 Comments – Post Your Own

#1) On December 30, 2009 at 10:30 AM, leohaas (31.41) wrote:

I am bullish on nat gas with you. Just one question: why do you refer to yourself in the third person? Are you royalty?

Disclosure: long UNG calls at the time of writing.

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