A barrel of oil contains about six times as much energy as a thousand cubic feet of natural gas. By that metric, at today’s WTI price of around $90/barrel, natural gas should cost $15/thousand cubic feet (tcf). Another way to look at the price differential is that at today’s natural gas price of around $4/tcf, a barrel of oil should cost about $25. Which is more likely?  This logic has been out of whack for quite some time.

The price of natural gas was decoupled from crude prices in 2007 and has never recovered. For a time in 2006, natural gas flirted with prices around $14/tcf, but that didn’t last long. The difference is due almost entirely to scarcity. Will natural gas recover even a little during 2011 or 2012? And how high will natural gas prices go?

The US Energy Information Administration projects an average price for natural gas of $4.24/tcf by the end of 2011, which is $0.15 lower than the average price in 2010. In 2012, the EIA expects a natural gas price of $4.41/tcf. In order to make a profit on natural gas, the industry needs a price in the range of $6-$8/tcf. That’s certainly not going to happen in the next 16 months unless some event of Biblical proportions should occur.

The 10 largest producers of natural gas in 2009 (the last year for which figures are currently available) were, in order, Exxon Mobil Corp. (NYSE: XOM), BP plc (NYSE: BP), Chesapeake Energy Corp. (NYSE: CHK), EnCana Corp. (NYSE: ECA), ConocoPhillips Corp. (NYSE: COP), Devon Energy Corp. (NYSE: DVN), EOG Resources, Inc. (NYSE: EOG), Anadarko Petroleum Corp. (NYSE: APC), Ultra Petroleum Corp. (NYSE: UPL), and Questar Corp. (NYSE: STR). Exxon’s top ranking includes its acquisition of XTO Energy, which had not officially been completed in 2009.

US natural gas production has changed dramatically since the adoption of horizontal drilling and hydraulic fracturing (fracking) of gas deposits trapped in nearly impermeable rocks generically called shale. Fracking makes much more gas recoverable and at a faster rate than conventional drilling. That’s one of the industry’s problems.

Leaseholders must drill within a specified period — usually three years — or lose their lease rights. Perhaps equally important is the nature of the hottest drilling areas themselves — shale gas fields, unlike their conventional counterparts, ordinarily ramp to full production much more quickly, hitting a peak quickly and producing an estimated 50% of lifetime production in the first year of operation.

The irony is that as shale gas production ramps up, conventional production is falling. The EIA estimates that natural gas production between now and 2035 will rise by an annual average of just 0.8%. But that’s a medium-to-long-term average. In the short run, production is rising quickly and depressing prices.

Over the longer term, natural gas prices are poised to rise. Gas-fired power plant construction is increasing as older and more polluting coal-fired plants are being taken out of service. The Daiichi Fukushima disaster in Japan has chilled nuclear power plant development and new US nuclear plants may never be built. Neither of these is having an immediate effect on natural gas prices, but both are medium-term boosters to gas prices.

A more significant impact could come in the somewhat longer term in global demand for liquefied natural gas (LNG). The bounty of US natural gas made available by horizontal drilling and fracking could be converted to LNG and shipped overseas. One US company, Cheniere Energy, Inc. (AMEX: LNG) that was planning to import LNG has been granted authorization to export LNG and expects to begin shipments in 2015.

None of this will affect natural gas prices for the rest of this year or into 2012. As summer’s heat gives way to cooler temperatures, demand for air conditioning will drop, reducing demand for natural gas. Demand will pick up again as the heating season begins, but summer is now the bigger demand period for natural gas and heating season supplies are likely to be plentiful.

An average price of no more than $4.10 is likely where natural gas will finish the year. For 2012 that could rise to $4.25, but anything higher seems unlikely. At least that’s the view from here.

Paul Ausick

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