Sometimes the most important impact on a raw material commodity comes less from its actual extraction and more from how product is introduced into new markets.
Indeed, that is becoming the next major development in North American natural gas. The expansion in liquefied natural gas (LNG) exports may well hold the key to turning a glut into advancing profit.
The LNG process cools gas into a liquid form, allowing it to be stored and transported via tanker. The liquid is then "regasified" on the other end and injected into existing pipeline systems. This provides for the development of genuine spot markets, since the movement of gas is no longer limited by how far pipelines extend.
The prospect of a long-term natural gas surplus has caused some to ask whether the additional volume coming on-line will simply depress prices. As I have mentioned here several times, this is not a question of conventional, freestanding gas reserves. This is all about unconventional production – primarily shale gas – and where it is likely to be increasing overall availability.
With the gas glut turning into a more permanent energy fixture in North America, the market will progressively become (even more than currently) one in which production will primarily meet regional needs, with contract swaps acting to offset differences between regions.
We will be moving into a very different way of balancing the market. Henceforth (and probably for decades to come) that balance will be affected by the knowledge that there is more supply than required, and it's easily able to move into the market.
In short, unlike crude oil – where we are beginning to see very early signs pointing to the development of a supply-constricted environment – gas will provide a supply-expansive environment.
The regulatory changes I recently discussed are certain to spur on the accelerating transition from coal to gas and renewables for electricity generation. And that will require additional gas, as will its expanding use in the production of petrochemicals. A cold winter will also drain stockpiles. In storage volume, we are currently well below the levels at this time last year (although those were record levels). Nonetheless, gas out of the ground – but not in the market – still occupies most of the pipeline capacity in the U.S.
And that simply points toward a continuing surplus.
The Advantage of Two North American Plays
Once we consider the impact beyond fulfilling local requirements, some plays will have greater benefits than others. Two are particularly noticeable in North America, and we have discussed both of them in the past.
The first is the rapid development of the Big Horn, Montney, and related basins in western Canada. The second is the Marcellus in Pennsylvania, New York, Ohio, and West Virginia.
Both of these are quite likely to provide volume more cheaply than some other basins.
In a surplus condition, cheaper volume will displace more expensive – especially when you consider broader geographical applications (inter-regional trade). Both North American reserves, therefore, should see increasing drilling, even when prices in the market as a whole are going down and drilling is stagnating elsewhere.
And that is the case currently. Despite natural gas contract prices below $4 per 1,000 cubic feet, production and rig usage are increasing in both the Marcellus and western Canada.
But what does this do to the profitability of production companies and pipeline operators? Doesn't feeding a glut always lead to a downward pressure on prices and a decline in profitability?
Not when a positive spread between production costs and market prices can actually be improved upon. And that's done simply by moving the gas to locations where the demand is so great it provides a premium on the return expected.
The development will benefit gas sourced from both conventional and unconventional North American basins.
But first, the current cost-pricing spread. The new shale and tight gas sources in British Columbia and Alberta are providing the likelihood of prices at a $1 to $1.25 discount to Henry Hub (the Louisiana location at which pricing for NYMEX gas contracts is determined). There are some additional costs for transport to distribution points, but recently completed spur lines to the TransCanada Mainline pipeline allow the gas to enter large markets.
In the Marcellus, wells are coming in cheaper than anticipated. The average well spud this year will come in profitable, at less than $3.60 per NYMEX contract, with a rising percentage coming in significantly below that level. Unlike western Canada, the Marcellus has the advantages of much closer proximity to end users and an increasing network of pipelines to serve both throughput and storage.
The concern, however, remains that the enormous amount of volume that both basins could put on-line would still flood the market and depress pricing, regardless of the additional demand for electricity generation or how cold our winters become.
Enter LNG... and two gigantic markets seeking additional gas for which they will pay a premium over North American prices.
Where the Demand Is
Asia needs the increased volume of natural gas to fuel its expansion. Europe needs it to wean itself from reliance on conventionally pipelined (and overpriced) Russian Gazprom OAO (PINK: OGZPY) volume.
Canada already has decided to move the new gas volume from western Canada to the Kitimat LNG terminal on the Pacific coast of British Columbia for export to Asia. Kitimat is scheduled to come into operation in late 2014. Already, there is a near certainty that its capacity will be doubled.
European requirements combine well with the rapidly expanding volume coming out the Marcellus. And on that count, there is Cove Point, Maryland.
Already in operation, Cove Point is the largest LNG facility on the U.S. east coast. As the need collapses for LNG imports into the United States – another result of our ongoing gas surplus – don't be surprised if this terminal begins reversing operations to export volume. This is tailor-made to provide a major outlet for additional production from the Marcellus.
LNG trade is no flash in the pan. It is becoming the single most important advance in balancing the global gas market. Currently, 86 gasification or regasification terminals exist worldwide; there are another 246 in planning stages or under construction.
That means, as additional volume comes out of the ground in western Canada, the Marcellus, or other basins in the United States, it will be shipped to higher-paying markets abroad.
Welcome to North America: the new Saudi Arabia of energy.
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About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.