NEW YORK, May 24 (Reuters) - U.S. natural gas futures have
posted an impressive rally since briefly trading below $2 per
million BTUs earlier this month, but the upside is increasingly
limited by coal prices and the prospect of more gas from now
unpopular dry shales.
The more than 40 percent rally in natural gas prices has
come even as major producers like Chesapeake Energy have
seemingly not cut output by as much as the market had hoped.
A string of better-than-expected weekly storage reports has,
at least temporarily, allayed fears that producers would be
forced to dump lots of unwanted gas on the spot market due to
storage limitations.
Increased switching away from coal by power utilities has
further helped, propping up natural gas demand.
Barclays Capital estimates that 7 billion cubic feet per
day of natural gas has displaced coal from the U.S. power
sector.
Some of this switching is due to utilities moving away from
coal and into gas due to tougher environmental legislation, but
the bulk of this incremental gas burn is due to economics.
Gas is simply cheaper right now. That in turn has forced
coal producers to cut output by 8 percent, according to BarCap.
So far, so good for gas. But here's where the problems for
gas bulls mount.
In the absence of a price for carbon emissions, coal
competes directly with natural gas.
So if U.S. natural gas prices rise to a level at which coal
is economically competitive, utilities will probably cut gas
consumption and switch back to coal.
The incentives to switch back to coal are considerable.
May U.S. utilities are sitting on growing coal inventories
and are forced to keep buying the fuel under long-term take or
pay contracts.
GenOn, for instance, has declared force majeure on
coal receipts due to a lack of storage space.
With coal prices ticking lower due to the slump in utility
demand, the upside to the gas rally gets closer.
Indeed logistical constraints, such as take-or-pay contracts
and limited coal storage space, may well force utilities to
resume coal burning even if the prices of gas and coal do not
converge.
DRY SHALE WALL
The other, longer-term barrier to a natural gas price rally
is the huge resources locked up in so-called dry shales.
With the plunge in natural gas prices, producers have been
curtailing output and drilling from basins like the Haynesville
Shale, which yield little in the way of more valuable liquids.
But this move away from dry gas output has not eliminated
this resource. If anything, the now unloved dry shales sit as a
cap on the upside to gas prices.
A sustained rally in natural gas futures would give
producers sitting on Haynesville acreage, for instance, a strong
incentive to put it quickly into production.
Indeed, it would likely spark a brief flurry of leasing as
gas producers tried to grab any opportunity to boost output as
prices rose.
The supply response is likely to be swift. After all, the
shale gas industry has honed its techniques in recent years,
cutting drilling and completion times and boosting well
productivity.
And many of these dry shales are among the best known
structures, so compared with conventional natural gas, the
exploration risk is minimal.
Over the longer term gas should benefit from environmental
rules that are squeezing coal out of the U.S. power market by
forcing the closure of older coal-fired plants.
Gas prices might also get some benefit from supply
discipline. Already big producers are coming under pressure from
investors to rein in empire building and focus more on the
bottom line.
But for the most part these two supports are weak.
Regulations can be overturned or watered down. Producer
discipline is hard to maintain if attractive short-term profits
loom.
So ultimately gas faces a few years at least of relatively
cheap prices.
It's a supply problem, after all. Gas has become much easier
to produce in large quantities. Relief for producers can only
come through new and bigger markets.
But breaking into many markets, like transportation fuels or
power generation, requires deeply undercutting the price of
incumbent fuels.
Give up the low cost of gas and new markets vanish.