Outlook for Natural Gas Prices in 2011

This post was written by Kenneth B. Medlock III, Ph.D., James A. Baker, III, and Susan G. Baker Fellow in Energy and Resource Economics & Deputy Director, Baker Institute Energy Forum

The natural gas market has undergone tremendous change in the past ten years.  We have moved from a consensus view in the early 2000s that natural gas supplies would increasingly come from LNG imports to a realization triggered by higher prices and innovation that massive shale resources can now be profitably developed. Today, we find ourselves at the beginning of a virtual new age in gas markets, or so conventional thinking goes.

Admittedly, by comparison to the first decade of the 21st century, the slate for 2011 is set to be fairly mundane. While the recent wave of drilling that was propelled by producers’ desire to hold acreage positions is likely to wane this year, other factors are acting to paint a fairly bullish picture for natural gas production in 2011. To begin, the recent entry into shale gas plays through both acquisition and joint venture – by firms ranging from ExxonMobil and Chevron to CNPC and Reliance – has provided much needed financial backing for continued drilling activity. In addition, the shift by producers to shale plays with higher liquids content, such as the Eagle Ford in South Texas, allows producers to generate substantial returns from the sale of liquids, thus sustaining a continued increase in their output of natural gas. Lastly, some shale plays, such as the Marcellus, are proving to provide attractive returns even at relatively low prices. Taken together, these factors indicate that prices are likely to average in the low-to-mid $4 range through 2011.

On the demand side, weather stands to play a major role in seasonal variability, as usual, but the strength of domestic production is likely to offset the bullish impacts of extreme cold this winter for the balance of the year. On a more structural level, the U.S. economy is, by most accounts, officially on the rebound.  In fact, this is evident in recent data which indicate industrial demand for natural gas is rising. This trend will likely continue through the year, especially to the extent that gas prices remain relatively low. In the power generation sector, demand for natural gas holds the promise of seeing some growth through displacement of older coal plants, particularly as gas prices continue to be suppressed by robust growth in domestic gas production. Residential and commercial sector demands, barring a bitterly cold January through March, should not do anything to substantially tighten the gas market.

All of this paints what appears to be a relatively ho-hum year for natural gas. Continued growth in gas production and moderate demand recovery indicate that prices will not likely rise substantially anytime soon. The real action for natural gas is on the horizon, which will be largely determined by the events that this year sets in motion.

For one, the ongoing study by the EPA aimed at examining hydraulic fracturing and water safety is a key bellwether for years beyond 2011. If any negative news surfaces regarding the study’s conclusions, which are due out in 2012, it could have dramatic implications for capital spending programs and production outlooks. This, in turn, this will impact futures prices, having a ripple effect to the current price. Even if industry can positively respond to any potential cost increases brought about by new regulations that may result, the short term impact will be to lift price.

Second, pending tightened EPA rules regarding plant emissions of non-CO2 pollutants regulated under the Clean Air Act are set to begin to take effect in 2013. This could have a dramatic impact on the outlook for demand, particularly as utilities are forced to decide whether to shut down old coal-fired power plants or retrofit them with the best available control technologies. Given the reported costs of the latter option, it is likely that these plants will be closed in many cases, leaving natural gas to fill the void. In fact, this is but one effect that regulators could have on the outlook for demand.  Any movement to put a price on CO2, while looking very unlikely at present, would stimulate demand for natural gas. In sum, these types of bullish indicators will tend to raise natural gas prices.

Finally, many are beginning to focus on the steps being taken to establish export capability from the U.S. and understand how those developments could begin to play a role. While LNG exports in 2011 will not have any real impact on the U.S. domestic gas market, continued low prices will accelerate producers’ efforts to find higher valued markets. This could eventually, if enough export capacity is established, lift U.S. prices closer to world parity. However, regulatory actions being taken domestically are likely to stimulate demand in the next 5-7 years, potentially increasing it by as much as 10-15 percent above its current level. Moreover, the risks associated with developing LNG export capacity from the largest and most liquid natural gas market (North America) in the world are not small. Much of the LNG world has pinned its hopes on continued growth in China. If anything happens to slow growth there, the world is set to see a glut of natural gas that will make the last two years pale by comparison.

In summary, 2011 looks to be a year in which some upstream rebalancing by producers (shifting from gas to liquids where possible) and some demand growth will lift prices slightly. But, do not expect a large run up. There is simply too much supply available to see a large increase. In fact, it appears that the largest uncertainties, and hence potential movers of price, come from the regulatory side. On that front, we are in a wait-and-see mode, as 2012 is sure to bring a lot of new information.