In my previous article on the subject of natural gas, I spoke about the fundamentals of supply and demand, and why I thought current market fundamentals supported a story for higher natural gas prices. In that article I pointed out that natural gas demand has increased 9.1% in the past three years, and specifically that power plant demand has increased 20% over the same period. In this article I will examine the reasons for this increase in demand, viewing the changes through the lens of both economic and political changes that have occurred in the past few years. I will then use this analysis to chart a course for natural gas price increases.
Preface
In the U.S. today we have a lot of different ways to generate electricity. However, the two most popular ways remain natural gas and coal fired power plants in all of their varieties. Without getting into all of the particulars, according to the EIA last year the U.S. generated ~4m megawatt hours of electricity. Of that generation natural gas and coal plants powered 2.7 million megawatts, and when including nuclear power generation the three combined for 3.5 million megawatts of power generation. From this we see that even though the U.S. has tried to pioneer an array of renewable and creative ways to generate electricity, we still rely almost completely on the traditional forms of power production. Therefore, I will limit my comments of power generation to the two largest - natural gas and coal - and leave the others aside.
Economic Factors
Over the past decade plus, natural gas plants have increased their market share of electric generation independent of the current severe decline in natural gas prices. In this section I will examine the history of this period by considering the costs of natural gas plants, and the attending change in practice.
When considering the economic factors of power plants, we must take a lot of variables into account. The standard analysis considers the following:
The cost of fixed maintenance remains pretty standard across all forms of power plants, but the first two costs vary wildly between natural gas and coal fired plants. According to the EIA, the following represents the budgeted cost for power plant production in the U.S.:
Cost Type | Average Construction (cost per megawatt hour) | Average Variable Maintenance (cost per megawatt hour) | Total Average Cost (per megawatt hour) |
Natural Gas | $24 | $57 | $91.9 |
Coal | $81 | $30 | $113.4 |
This chart presents us with many interesting facts.
Granted, these numbers reflect a general average across all of the U.S. and across all different types of natural gas and coal generators, with prices varying from location to location and type to type. But from this meta perspective we see the current advantages operators have in constructing natural gas plants over coal plants.
We should not consider this current situation a one off anomaly, but rather they reflect a long term trend in the power generation business. According to the EIA, natural gas fired plants has notched steady gains in adoption over the last 14 years while the use of coal has remained stagnant. In 1997, coal generated 1.8 million megawatts of electricity, and last year it generated 1.7 million megawatts, a modest decrease. However, natural gas generated .5 million megawatts of electricity in 1997, but has since doubled to over 1 million mega watts last year. This increase has occurred steadily over the past few years, averaging an annual compound gain of 5.61%.
Looking at these figures from a different angle, in 1999 U.S. power plants used 950 million tons of coal for electricity generation purposes, and in 2010 they used about 1 billion. On the other hand, power plants used 5.3 trillion cubic feet of natural gas in 1999, and over 7 trillion 2010, a 33% gain.
The increasing adoption of natural gas over such a long period of time does not reflect the current market for cheap natural gas, but rather the long term technological gains that have allowed natural gas to operate more cheaply and efficiently than their coal fired plant counterparts. Therefore, moving forward the demand for natural gas in this space will only increase, which should move prices for the commodity higher as well.
Political Factors
Over the past decade the drum beat of global warming has grown louder and louder with time. Major public figures, most notably former VP Al Gore, have taken the position that global warming poses a tremendous risk to our survival. With a democratic administration this message has grown louder and louder, and will surely play a role in future energy policy of the U.S.
These concerns, as they effect the power generation business, have had two major policy events impact it over the past couple of years. These events have centered on the ability of the EPA to regulate emissions of coal under the Clean Air Act of 1990. Giving the EPA ability to regulate greenhouse gasses will have a permanent change of the economic landscape of the power generation business.
Chronologically, the first event came in 2007, when the Supreme Court ruled that the EPA had to the right and the obligation to decide whether or not greenhouse gasses affected public health, and that if they did they would have the obligation to regulate their emissions. This ruling has not taken effect yet because of continued legal and political haranguing, but it has set the stage for the possibility of a major decrease in the use of coal as opposed to natural gas.
The second event occurred late last year when the EPA announced it would regulate emissions of mercury and other toxic pollutants. These regulations will place a heavy burden on the coal industry, and will shift many power producers to natural gas in order to avoid the heavy regulatory and economic burden.
This shift will in turn drive demand to natural gas fired plants, and should increase prices for natural gas.
Before I turn to my conclusions, in brief I believe the argument I laid out above supports a bullish position for natural gas. I lay out in my previous article how I think those who believe in my theory can play this trend by betting on United Natural Gas (UNG), or First Trust Natural Gas Reserve Fund (FNG) so please see there, and in the comments section for more details.
Conclusions
A lot of the conversation over the past couple of weeks regarding natural gas has centered on its effect on the transportation industry. The price of fuel dominates American life, and with the price of conventional gas going higher and higher, the pressure to find an alternative has grown stronger and stronger.
Commentators have argued that this increased demand from the transportation issue will drive (no pun intended) the prices of natural gas higher. While I think the point has major validity, I find the focus misplaced. The shift from conventional gas, to natural gas will take a long time. The lack of consumer cars that have natural gas powered engines, and the lack of infrastructure, surely pose a huge roadblock for the adoption of this fueling option.
Additionally, while the price of gas soared in the recent weeks and months, the price of gas has notoriously fluctuated wildly, affected by not only supply and demand, but also geopolitical issues as well. I am curious to see if and when gas prices decrease, if the issue still remains relevant.
Power plans, in contrast, already have a major share of the market, and have shown major long term growth as I have shown in this article. Additionally, while cars have increased their usage of natural gas in the past five years, they still only make up 1% of natural gas usage, while power plants make up 31%. Therefore, I think investors should refocus their sights on how power plant demand will affect natural gas prices both in the long term and short term.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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