The Remaking of the US Power Sector
Low natural gas prices are turning the energy sector upside down. Gas prices are at their lowest level since 2002, having fallen 54% in the past 12 months. The low prices have stopped construction of new gas storage facilities, led to interest in LNG export terminals and made existing gas-fired power plants more valuable. Traders have been betting for more than a year on the price to rise. Forward price curves continue to show a steep increase during a period when the ratio of gas to oil prices has gone in the last year from 26 to more than 50, against a 15-year average of 11. Will the costly new export terminals be finished in time to earn a return? Will most of the new gas-fired power plants built end up in rate base? Are low gas prices a source of opportunity as well as peril for the renewable energy industry?
A group discussed these and other questions at the Chadbourne global finance and energy conference in June.
The panelists are Christopher Smith, a managing director of Energy Management, Inc., Paul Cavicchi, executive vice president of IPR-GDF SUEZ Energy, Roberto Simone, managing director and head of project finance at Société Genérale, and Noam Ayali, a project finance partner with Chadbourne in Washington. The moderator is Ben Koenigsberg from the Chadbourne New York office.
MR. KOENIGSBERG: Production of natural gas in the US grew nearly 8% in 2011, principally because of shale gas resources. Estimates of recoverable shale gas are between 700 and 1,800 trillion cubic feet. US shale gas production increased fivefold between 2006 and 2010, and the Energy Information Administration estimates shale gas will ultimately reach 13 trillion cubic feet by 2035. The questions are what are we going to do with all this natural gas and how will the renewable energy industry will react? Chris Smith, gas prices are currently at about $2 an mcf. Do you expect them to increase or stay put?
Natural Gas Price Outlook
MR. SMITH: They will increase. The thing to remember is that $2 an mcf is the spot price. The forward price curve matters as much or more than the spot price. Even within a year, gas prices vary considerably.
Gas prices will increase for two reasons. One is that the current price of gas on the spot market appears to be below the average total cost. The average total cost is the marginal cost to produce plus a return on capital. It doesn’t look like gas producers are recovering their costs, let alone earning a return, at current prices.
The other reason is demand will increase. We had a very warm winter with the result that producers stored a lot of gas. You are now seeing a runoff of that gas, which is helping to keep prices low. This is a temporary phenomenon.
MR. KOENIGSBERG: Demand may also increase relative to supply if we start to export gas to other countries. A lot of gas import facilities are sitting idle currently. These facilities are now being made bi-directional. However, the politics of gas exports mean that only one company is authorized currently to export. Should the US allow more gas exports?
MR. SIMON: In the spirit of full disclosure, we are advising Cheniere, the export terminal to which you referred. The simple answer is absolutely: the government should permit companies to export natural gas, but I think the broader question is: does it really make sense, from the standpoint of US energy policy, to export our natural gas? We have an abundant resource. If you look at the forecasts, even in fairly high demand growth scenarios, natural gas prices are not forecast to rise dramatically over the next eight to 10 years.
Exports are a source of revenue. It is in the US national security interest to be part of an integrated energy market and to have other countries look to us as a source of energy.
Finally, remember that it was not so long ago that people were talking about natural gas imports and building something like 33 LNG import terminals. People forget how difficult it is to find enough credit worthy parties to sign terminal use agreements under which they are obligated to make capacity payments. The critical element in building an LNG export terminal is finding someone of sufficient size, credit quality, capability and desire to take natural gas in the United States and market it to the rest of the world. There are not many companies who are capable of doing that or have an interest in doing it. It is this, rather than politics, that will limit the number of export terminals.
MR. CAVICCHI: Exports are likely to have a marginal effect on gas prices in the United States given the quantity of shale gas being produced.
MR. SMITH: The Energy Information Administration is predicting that we will have 16 bcf a day of export capacity within the next five to 10 years. Let’s assume that all the planned export terminals are built. The EIA also estimates that we will average about 10 bcf a day of actual exports. The United States uses around 65 bcf a day now, and this is in a very depressed environment. Natural gas consumption is linked to industrial demand. We are in a very soft economy.
If we start exporting 10 bcf a day, that is equivalent to a 15% increase in demand. That is a significant swing. A lot of industrials look at this potential increase in demand and see themselves being compromised economically.
This underscores the need for diversification. I used to work at Enron. I was a young associate and was sitting around the table at lunch with gas industry veterans like Stan Horton, who was instrumental in developing Cheniere, and they would talk about what they wanted to do in life after Enron because things were not looking so good at the time, and they were saying “LNG is where it is; we need to have import terminals because we are going to run out of gas in 10 years.” This was 2003. Here we are now. The import terminals are idle, and the talk is about exporting gas and turning the terminals around. It underscores how volatile this market can be and how things can play out differently than what you expect. I have never seen a long-term forecast that is correct. That is why you have to be diversified.
MR. KOENIGSBERG: If you don’t believe forecasts, then what do you make of the EIA forecasts?
MR. SMITH: The EIA report was controversial. Some people said the elasticity of supply is much greater than EIA assumes. EIA made optimistic assumptions about the number of export terminals that will be built. All of that said, the EIA report is useful because the agency has no axe to grind. It tried to take a static look at a dynamic market. At the end of the day, any forecast is based on a number of assumptions. If any of the assumptions proves off the mark, then the outcome changes. One thing I know is if the price stays low, demand is likely to increase until the price finds a new equilibrium.
MR. AYALI: People in the gas business had a very negative view of the report. The EIA conclusions were at odds with other studies by Deloitte and the Brookings Institution. These other studies suggested the effect of exporting LNG on domestic prices for industrial consumers and for the power sector will not be that significant.
MR. SMITH: These other studies made different assumptions. What really matters is what the marginal cost of production is for that last molecule of gas. It is that simple. A lot of people like to say we have 100 years of supply. That’s not what determines the price at any given moment. What matters is whether you can feel confident relying on that commodity over the long term. It is not clear that betting on continued low gas prices is a good idea. Even though the shale gas is now contributing significantly to US gas supply, gas from conventional sources remains something like 67% of US supply. Future supply will depend on how successful people are in developing reserves in different parts of the country and moving the gas to population centers. Regional politics will play a role as will national energy policy.
MR. KOENIGSBERG: US gas reserves are potentially enormous.
MR. SMITH: That’s right. The US has potentially enormous reserves that have been known for some time. My point is that the US is not a monolith. Markets are local. You have to move the gas to different markets. This requires infrastructure. Building new infrastructure is never easy. We tend to be too focused on prices at the Henry hub.
MR. SIMON: I disagree with Chris. I think what has changed dramatically in the last five or six years is gas used to be traded in local markets, and while this remains predominantly the case, the price is increasingly being set on the international market. If you look at the guys building export terminals, they are not taking the Henry hub price risk. Their view is they are going to manage a global LNG portfolio. If the price of gas increases abroad, it makes sense to export gas until there is no longer an opportunity for arbitrage profit.
MR. SMITH: I don’t disagree with that. My point is that if you are a New York utility trying how to decide how to provide reliable electrical service, you are focused on more than just the natural gas price. You are thinking about the reliability of supply and your ability to build the required infrastructure given local politics. You still have the problem of delivery of gas into the local markets.
MR. CAVICCHI: We have to take a view on pricing. We bring a parade of consultants through our offices. It is amazing how wide the range of forecasts is. You get anything from gas remaining at $2 an mcf to increasing to $4.50 an mcf by 2013.
MR. AYALI: The $4.50 figure is where producers hope to see the price.
MR. CAVICCHI: What else can a gas producer tell his bankers? Gas will be $4.50 an mcf. What does a wind developer tell his bankers? Gas is going to be $5, $6 or $7 an mcf. You can do all the wishing you want. Gas producers are boosting their efficiency at the rate of 30% year over year. This is reducing the cost to drill new wells. A lot of consultants are projecting as little as $3.50 to $4 an mcf as the cost to produce clean gas. The long-term cost curve continues to come down; this all bodes well for exporting gas. It bodes well for finding new uses for gas. I think trucks will eventually run on LNG. Demand will be created in other areas.
MR. SMITH: What has changed more than anything else is the risk-for-return trade off for gas producers. Everyone used to be chasing conventional reserves. You had production curves that showed how the price of gas was going to fall off a cliff. That was the assumption that led to the development of so many import terminals.
Tapping conventional reserves is like letting the air out of a balloon; as the pressure falls, the reserves drop off. Shale is different. You can basically drill a well anywhere from Tuscaloosa, Alabama to Syracuse, New York or from Ohio east to Garrett County, Maryland and, with a relatively high degree of certainty, you will find gas and you know what the production curve will look like. Gas output will peak very quickly and then drop until it levels out. In Kentucky and West Virginia, they have shale gas wells that will produce gas for 70 years. There is less risk associated with drilling a shale gas well.
The other issue is that drilling into a conventional reserve requires building a lot of infrastructure to get the gas to market, but the conventional reserve might only last 10 to 15 years. That means the cost of producing conventional gas is much higher because the cost of the related infrastructure has to be amortized over a much shorter time period. We are seeing a lot of majors move into shale gas. All of this suggests less volatility in pricing.
MR. KOENIGSBERG: Paul Cavicchi, do you agree that we are headed into a period of less volatile gas prices?
MR. CAVICCHI: I worked for a guy who was one of the founders of the independent power business; he talked about a gas bubble for 20 years that never happened. He was very innovative, and I don’t mean to criticize him, but gas has been tremendously stable in the United States. The volatility occurred in 2005 when the Gulf Coast was hit by multiple hurricanes. You don’t have that OPEC risk with gas. The hurricanes led to about three years of high prices. If you remove them, then gas prices have been relatively smooth. They should remain that way.
MR. KOENIGSBERG: So low volatility.
MR. AYALI: We look at the pricing from a very US-centric perspective. Shale gas is a global phenomenon. Argentina, China and parts of Europe are all producing shale gas, and GDF and other aggregators will have a lot more options for where to find gas supplies. People should take that into account when examining the US market.
MR. KOENIGSBERG: What do you see as the biggest barrier to future production? Is it that there is too much supply in relation to demand? Is it regulatory?
MR. AYALI: I think the industry is taking a breather right now in two respects. First, $2.50 is not a price that gas producers want to see, so they are shutting in production. Those who can afford to do so are sitting back and waiting for prices to increase. Second, the US Environmental Protection Agency came out with new guidelines for shale fracking, and I think people are pausing to digest what EPA said and trying to assess how the different states will react.
Opportunity for Renewables?
MR. KOENIGSBERG: How are low gas prices affecting the renewable energy industry? Is there any opportunity for renewable energy producers or are they purely a source of pain?
MR. SIMON: The obvious answer in the short run is that low gas prices are a headwind. The price of wind electricity has been coming down over time. It is becoming reasonably competitive, notwithstanding the low gas prices. Solar prices continue to come down. We have a tendency to look at the world in a static view and underestimate technological changes.
Does a low price of gas help from a perception perspective? No. Will it help from a political perspective, given that we as a country have never had a national energy policy? Does it make it more difficult to argue that renewable energy projects should be subsidized? Maybe.
Do I think there is an ingrained desire for these sorts of technologies to be used as a source of energy? If you ask my kids, they don’t pay the bill, so sure, solar, wind, these are all good things. I think that perception is shared by adults in parts of the country, but not everywhere. In at least one state, people are so concerned about global warming that they are prepared to pay as a cost of society to have some diversity in energy sources.
The move to renewable energy will continue and be driven by technology more than anything else.
MR. CAVICCHI: I agree. Low gas prices are a serious headwind in the short term. However, you can argue that it will give governments room to be more proactive with green initiatives. The price of electricity in New England was $70 a MWh. To the extent low gas prices push down the marginal cost of electricity, it creates more head room to introduce public policy supports for renewable energy without increasing electricity prices.
MR. SMITH: There may be a difference between theory and reality. The theory is that what matters are the overall costs, not the specific cost of any one element in the energy supply. Theoretically, with gas prices falling as far as they have, it should be much easier for people to accept subsidies for renewable energy because the cost overall is so much less. But the reality is that people focus on what they are paying for their electricity in any given contract.
MR. AYALI: The interesting thing is prices over the last year have been in the $2 to $2.50 range, and there has still been continued development of renewable energy projects. The question is whether we are at the bottom of the trough and are starting to climb back up as gas prices start increasing again and the price differential narrows.
MR. SIMON: I agree with Paul Cavicchi that there is a trend to want to be green, but the broader question is whether we are ever going to have a coherent energy policy. A patchwork of tax credits, cash grants and state renewable energy mandates is not the most efficient way to do it if you want to build out a segment of the energy market.
MR. KOENIGSBERG: Maybe there is a way for the renewable energy industry and the natural gas industry to work together, which leads me to my next question. Should the renewable energy industry support the exportation of natural gas from this country?
MR. AYALI: The knee-jerk response is to say yes. Anything that increases the price of gas is good for the renewable energy sector, but there are other reasons. You need a coherent energy policy that will help support energy source diversity, and the only way to achieve that in the political environment is to present a sensible, unified approach to it and not make policy what results from individual pressure groups whose efforts will inevitably be perceived as an effort to grab market share.
MR. KOENIGSBERG: Paul Cavicchi, do you share this view?
MR. CAVICCHI: Absolutely.
MR. KOENIGSBERG: Do we think that new gas-fired power plants will end up in rate base or will they be owned by independent generators?
MR. CAVICCHI: I don’t see independent generators owning the next wave of gas-fired power plants without long-term contracts from utilities to buy the output, and such contracts are hard to come by.
MR. SMITH: The markets that are in most need of power are the deregulated markets in Texas, New York and New England. There will be an emphasis on developing in those markets. To the extent utilities in those markets have been forced to divest their generating assets and rely on the market to purchase electricity, you will see plants owned by independent generators. In other states, they will go into rate base.
More Export Terminals?
MR. KOENIGSBERG: Roberto Simon, these new LNG export terminals are very costly. Do we think, if gas prices are expected to increase, they will be finished in time to earn a good rate of return?
MR. SIMON: Absolutely. I say that because terminals being built in other parts of the world cost about a third to half of those here to build, but those terminals are one to three years behind the new terminals in the US. Three factors are keys to whether the export business succeeds. They are the capital cost of the terminals, the cost of gas transportation and the price of oil. US LNG is competing against oil-based products to go to Asia and Europe. From 2015, new LNG export facilities will be coming on line in Australia, East Africa and so on.
MR. KOENIGSBERG: Some more views?
MR. CAVICCHI: A lot of companies are willing to bet a few billion dollars on a curve projecting $5 gas in 10 to 15 years, a delivered price for LNG into Asia at $55 to $60 an oil barrel equivalent while oil currently costs from $85 to $100 a barrel and could go higher.
MR. KOENIGSBERG: If the contracts have a pass through of the natural gas price, the change in the price should not adversely affect the LNG export terminal as long as the capacity charge the terminal receives covers the return.
MR. AYALI: The real question is whether the bank market will be there. Cheniere will cost $3.8 billion. Is there enough capacity for two or three of these terminals to be under construction at the same time?
MR. SIMON: The key element is liquidity. There is a ton of liquidity in the market right now.
Cheniere has two trains. It has 4.5 million tons per annum of capacity per train. We will raise close to $3 billion from the commercial bank market alone. There is a ton of money looking for good investments. The guys who are on the sidelines to a degree are the European institutions, but there are a lot of other sources of capital to tap. What Cheniere is demonstrating, and Cameron will demonstrate, is if you have a sound contract structure for a project, there is capital to be found. The money will come from banks, the capital markets, the export credit agencies, Chinese banks, Korean banks. There is no shortage of liquidity. Money is not as cheap as it used to be, but capital is readily available.