An Economic Evolution in the Making: Natural Gas

It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.” – Charles Darwin.

Since the birth of the Republic in 1776, the U.S. has always been one of the most adaptable nations. Americans learned to fight a guerrilla war against the British; emigrated westward across the continent; embraced the canals, the telegraph, railroads, electricity, the automobile, and computers (while the British destroyed their own computers post WWII); and eventually–even central banking in 1913 (the First Bank and the Second Bank of the United States notwithstanding).

At the same time, Americans have proved to be very stubborn in certain policy areas. Central banking was one of them. Then there was the abolishing of slavery. It also took many years for the U.S. to enter WWI and II–and many decades for the U.S. to assume responsibility as a global superpower.

The development of atomic weapons in 1945–and the subsequent development of global delivery vehicles such as the ICBM and SLBM–forced both the U.S. and Soviet Union to adapt their respective national security policies. At the height of the Cuban Missile Crisis, there were runs on rifle sales; while fights broke out in grocery stores. Senate majority leader Mike Mansfield and his wife flew home to Montana in case of a nuclear war. Philosopher Bertrand Russell urgently cabled Kennedy:

Your action desperate. Threat to Human Survival … End this madness.

With the potential for total annihilation of the human race,  there needed to be a more conciliatory policy based on open dialogue and mutual benefits. Ironically, the development of this most destructive weapon resulted in a general peace–one that has lasted for more than 50 years.

Fast forward to 2012, or nearly 40 years after OPEC first welded the “oil weapon” over the Yom Kippur War. It has also been over four years since WTI crude oil spiked to nearly $150 a barrel. As seen in the chart below, there has been a turn-around in U.S. crude oil production since 2008. The rise in U.S. oil production (and a corresponding decrease in oil imports) is projected to continue until at least 2020.

Despite massive drilling over the last several years, the EIA still expects the U.S. to import nearly 40% of its oil consumption by 2020. With the U.S. economy still limping along (and at the mercy of >$90 a barrel oil); and with gasoline prices spiking to over $5 a gallon in parts of Southern California this week, it is apparent that there needs to be a more coherent national energy policy.

As we have mentioned, we remain optimistic on alternative energy technologies, including solar, wind, second-generation biofuels, and energy storage technologies. Commercialization of such technologies (which would result in a significant reduction in oil consumption) could take several years–or several decades. In the meantime, we believe natural gas to be a reliable “bridge fuel”–mainly through the power grid into electric and hybrid vehicles. Today, the Henry Hub (based in Louisiana) spot price stands at just $3.25/MMBtu—something inconceivable just 7 years ago (when winter prices spiked to $15/MMBtu). Storage remains at all-time high levels for this time of the year. More important, the volatility of natural gas—which peaked at more than 3x that of WTI crude oil—has died down.  This is not surprising in light of the immense shale gas supply.  What has been less covered is the increase in natural gas storage levels—not just current working gas but total storage gas levels/capacity.

Working Gas in Underground Storage Compared with 5-Year Range

As shown in the above chart (courtesy of the U.S. EIA), working gas natural gas storage levels are sitting at the high-end of its five-year range—272 Bcf (billion cubic feet) higher than last year and 281 Bcf higher than the five-year average of 3,372 Bcf.  This extremely high working gas storage level has two direct effects: 1) reduce the absolute price of the commodity; and 2) reduce its volatility—as a colder-than-expected weather would no longer fuel the fears of a natural gas shortage.  This is important, as the 2005 winter spike in natural gas prices was partially due to the fears behind an actual shortage of natural gas (further fueled by speculation by natural gas traders).  Indeed, as shown in the below chart, the total natural gas storage level in the U.S. has risen by at least 500 Bcf since 2005.  While 500 Bcf makes up only 6% of total storage levels, an increase of 500 Bcf in working gas levels is sufficient to dampen volatility significantly, as current demand—even during a colder-than-expected winter—is not enough to trigger fears of a natural gas shortage. A dampening volatility–combined with low prices–make natural gas a very compelling “bridge fuel” for U.S. consumers and (hybrid and electric) automobiles for the rest of this decade. With the Henry Hub spot price at jut $3.25/MMBtu, there is significant potential upside; and minimal downside. We are thus bullish on natural gas and regard shares of natural gas production companies at current prices as similar to perpetual warrants.

U.S. Total Natural Gas Underground Storage Capacity  (Million Cubic Feet)

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