Energy price declines not limited to oil

With all the focus on falling crude oil prices (chart below) as well as sharp reductions in the cost of gasoline (including retail), jet fuel, and heating oil, it's easy to miss the fact that prices of other energy products have been hit quite hard as well

Source: barchart

Here are a few examples:

1. US natural gas price declines have been spectacular.

March 2015 futures contract (source: barchart)

Natural gas valuations are of course responding to the correction in oil. But other factors include strong US gas production and the normalization of gas inventories in storage after the harsh 2013-14 winter.

2. Coal prices have fallen sharply as well, particularly for Appalachian coal (see chart). Coal traded in Asia (chart below) has also been under pressure.

Source: barchart

3. Price declines have not been limited to fossil fuels. Even uranium futures have been selling off in spite of rising Japanese demand, as nuclear reactors go back online - see chart.

4. Expectations of weakening profitability for alternative energy sources, including wind and solar, are showing up in the significant share underperformance against the broader markets (which started with declines in crude prices).

          Red = solar shares; Blue = S&P500

           Red = wind energy shares, Blue = S&P500

Source: StockCharts.com

5. With major sources for power generation becoming cheaper, electricity prices (chart below) have declined as well.

January-2015 PJM Monthly On Peak (source: barchart)

As discussed before (see post), this is quite positive for the US (and global) economy. However a number of industries involved with products discussed above will be severely disrupted in 2015, resulting in debt restructuring, consolidation and some job losses.

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Reasons for recent rally in natural gas

The recent outperformance of US natural gas over crude oil has been quite spectacular - some 25% just since the beginning of March-2013.

Source: Ycharts

As usual, we want to understand the fundamentals behind this divergence. Natural gas of course is primarily used for power generation and heating in the US, while crude oil demand is driven by other, more global factors. We've discussed the recent weakness in crude oil earlier (see post). The strength in natural gas on the other hand has been impacted by two key developments.

1. The warm winter of 2011-2012 caused a large build in inventories, which ended up weakening natural gas prices. In areas like the Northeast however (and some other regions that rely on natural gas for heating), the warm weather pattern has been reversed this past winter.

Source: Rutgers University

2. Faced with a glut of gas in storage and protracted price weakness, energy firms such as Chesapeake Energy have curtailed production - as can be seen in the recent trend of rig count.

Source: Baker Hughes

That  has led to declining amounts of gas in storage, which has reached levels that are more consistent with historical averages ...

Source: EIA (blue = latest gas in storage for lower 48 states)

 ... and pushed natural gas prices comfortably above $4/mmBtu.

Source: Barchart

These higher prices will now halt and possibly reverse the declines in gas rig count and spur more activity in natural gas production. It may take some time to get to a balanced state, given the rapid changes in the US gas industry (see discussion). The oil-gas relative divergence however has likely played out its course for now.

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From our sponsor:

EIA forecast for energy production/consumption in the US; massive spike in tight oil output

Periodically the US Department of Energy publishes a long-term forecast on the state of energy fundamentals in the US. Their current projection looks as far out as 2040 (whatever that's worth). Here are some key aspects of the forecast. The tight oil (see definition) contribution to US production is quite amazing. See some comments in brackets "[ ]".

EIA: - 1. Crude oil production, especially from tight oil plays, rises sharply over the next decade. Domestic oil production will rise to 7.5 million barrels per day (bpd) in 2019, up from less than 6 million bpd in 2011.

Source: EIA

2. Motor gasoline consumption will be less than previously estimated ... reflecting the introduction of more stringent corporate average fuel economy (CAFE) standards. Growth in diesel fuel consumption will be moderated by the increased use of natural gas in heavy-duty vehicles. [this involves the use of compressed natural gas (CNG) in trucks, particularly municipal vehicles such as garbage trucks]

3. The United States becomes a net exporter of natural gas earlier than estimated a year ago. Because quickly rising natural gas production outpaces domestic consumption, the United States will become a net exporter of liquefied natural gas (LNG) in 2016 and a net exporter of total natural gas (including via pipelines) in 2020. [nat gas production growth looks impressive]

Source: EIA

4. Renewable fuel use grows at a much faster rate than fossil fuel use. The share of electricity generation from renewables grows to 16 percent in 2040 from 13 percent in 2011. 

[Here is the chart of the overall consumption forecast by fuel - note that this is not just for electricity, it's total usage]

Source: EIA

5. Net imports of energy decline. The decline reflects increased domestic production of both petroleum and natural gas, increased use of biofuels, and lower demand resulting from the adoption of new vehicle fuel efficiency standards and rising energy prices. The net import share of total U.S. energy consumption falls to 9 percent in 2040 from 19 percent in 2011. 

[The chart below shows the production/consumption growth. Note that this is total energy, not just oil. The gap in oil is expected to drop from 45% in 2011 to 37% in 2040]

Source: EIA

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From our sponsor:

Natural gas up nearly 100% from April lows

The US natural gas in storage is finally showing a more seasonal pattern, with the first sign of declines due to seasonal demand increases. This rise in demand was helped by low temperatures in the Northeast that followed Hurricane Sandy. Nuclear power plant outages have also provided support, as gas-fired plants have been used to offset the loss of nuclear generation.

Weekly changes of gas in storage (source: Econoday)

With better demand fundamentals - especially after the hot summer that burned off some excess supply via increased power usage (see discussion) - natural gas continues to rally. Henry Hub spot price is now about 100% above the lows reached in April.

Natural gas spot price $/mmbtu (source: Barchart)

In the long run, a number of pipeline projects should reduce excess supplies from the Marcellus Shale area, lowering regional price differentials and providing some stability to the business.

EIA: - As production in the Northeast United States has grown, particularly from the Marcellus, insufficient infrastructure has led to excess supply and depressed prices in some areas. Several major pipeline expansions and new projects are planned in the coming years to help further ease constraints in moving gas out of the Marcellus Shale region.

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From our sponsor:

Rail freight prices for coal rise; firms able to pass increasing costs

The US Department of Energy today released historical data on costs of transporting coal via rail to electric power plants. Price increases vary considerably across locations, but at the national level these costs are up 50% in the past decade.

EIA: - The average cost of shipping coal by railroad to power plants increased almost 50% in the United States from 2001 to 2010. Railroad transport accounts for more than 70% of U.S. coal destined to the electric power sector, so changes in rail rates can have an important impact on the cost of coal delivered to power plants. Though they vary significantly, transportation costs accounted for 40% of the average overall cost of coal delivered at electric power plants in 2010.

Source: EIA

A more up-to-date general rail freight data sets (up to Q2-2012) from the Department of Transportation seem to point to even larger increases. Given the shift toward natural gas by US utilities (chart below), shouldn't rail freight prices stabilize (aside from fuel prices)?

Source: EIA

Apparently a great deal of the freight costs have been driven by rising costs of operating railroads. The Association of American Railroads keeps track of price level of inputs to railroad operations: labor, materials, and supplies, and other operating expenses. Excluding fuel costs (which the rail industry charges separately as a "surcharge") the operating costs seem to have risen about as much (on a percentage basis) as the shipping costs paid by the coal companies. Of course the Association of American Railroads has an incentive to pump up the index, but they claim to have some regulatory oversight.

All-inclusive rail operations cost index less fuel (Q4-2007 = 100, source: Association of American Railroads)

This is bad news for the coal industry, particularly if rail firms continue to pass their cost increases to the clients. Except in a few cases, rail demand seems to be sufficient to maintain pricing power. The EIA pointed out that in some cases the cost of shipping is higher than the actual price of coal. It is only a matter of time before natural gas takes a larger share of that business.

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Natural gas in storage approaches historical levels

US natural gas prices have stabilized just under $3.50/MMBTU (for Henry Hub delivery NYMEX futures) - about 20% above the August lows. Production continues to be considerably higher than in 2011 but growth in production has finally slowed. Rig count in the Gulf and elsewhere is lower.

With the hot summer we've had, some of the excess in storage (from the unusually warm winter) has been burned off. The supply in storage is now close to historical norms, though still in the high end of the range.

Another warm winter like the last one however could do some damage to this industry, as it remains vulnerable to oversupply risks (particularly with dry shale gas production still going strong - chart below).

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The US had 17 of 25 highest natural gas burn days this summer

It's no surprise that this summer resulted in the highest natural gas burn rate on record. Low natural gas prices allowed more substitution by power plants (gas instead of coal) and consistently high temperatures across the US (particularly in the Midwest) created the demand.

EIA: - According to Bentek Energy, estimated daily natural gas use to produce electric power (also called power burn) averaged 26.3 billion cubic feet per day (Bcf/d) so far in 2012 (Jan 1 - Aug 15), up 24% compared to the same period for 2011. Bentek Energy, which has been estimating power burn since January 2005, said that 17 of the 25 highest days of power burn since 2005 occurred this summer between June 28 and August 9.

The two main drivers of the increased use of natural gas at power plants this year are weather and a structural shift toward generating more electricity from natural gas-fired power plants.

Source: EIA

This brought the US natural gas inventories - which were unusually high due to the warm winter and high production levels - closer to normal levels for this time of the year.

Source: EIA

Here is the breakdown of where in the US the burn rate was the highest. Not surprisingly it roughly follows the drought pattern (the map shows usage relative to historical patterns).

Source: EIA

In spite of the heavy usage, natural gas prices remain subdued.

Source: Barchart

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The rapidly shifting supply fundamentals in US natural gas

The story of US natural gas is a good example of how quickly the supply begins to adjust to changes in demand when free markets are allowed to work. Here are the facts.

1. Supply of natural gas is now substantially above the 5-year range. At this time of the year the cycle of withdrawal from storage ends and the injection cycle begins (the inflection started earlier this year).

Source: EIA

2. Prices adjust violently to the news of oversupply in storage.

Natural gas futures price (Bloomberg)

3. The market action quickly translates into an adjustment to the "real economy" as the number of natural gas rigs declines (within months).

Source: Barclays Capital

At the same time demand for natural gas is increasing, with gas replacing coal for some of the US power generation. Natural gas will even replace gasoline for certain applications over time. Ultimately this should lead to the leveling off of supply and the stabilization of natural gas prices. The market is already pricing that in via a very steep futures curve. Gas prices are expected to almost double two years out.

Nat gas futures curve (Bloomberg)

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US coal production declines as the industry faces further stress

Here is a follow-up to the post on the declining US coal demand. As natural gas hits a new low today, the pressure on US coal industry increases further.

Natural gas nearby futures contract (Bloomberg)

The impact is unmistakable. The latest data from EIA is showing 2012 coal production levels materially below the 5-year range for this time of the year.

Making things even worse for the coal industry is the new EPA proposal to reduce carbon emissions by electricity companies. This proposal would turn the new coal-fired power plants into money losing investments.

Reuters: The first-ever U.S. proposal to restrict carbon dioxide emissions would have once been a major shock to electricity companies by making it uneconomic to build new coal-fired power plants.

But the irony is that the essence of the EPA's proposal has effectively already been usurped by low natural gas prices, which also turn coal-fired plants uneconomic.

Reuters: But the discovery of abundant supplies of cheap natural gas means that many of those plants won't get built anyway - making the Obama administration's plan, while painful for the coal industry, much less relevant.

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Signs of demand destruction: the US consumer is saying NO to high gasoline prices

The NYMEX gasoline futures price hit another recent high last week and is sure to push up gasoline prices at the pump. This development will add to the lingering concerns about the nascent US consumer recovery.

NYMEX gasoline nearby contract (Bloomberg)

Crack spreads (spread between distillates and crude oil price) have recovered from the lows of December. It means that refinery margins are now quite high, with refineries enjoying fat profits once again. As an example Valero Energy (VLO), a major US refiner is up 27.6% year to date on a total return basis.

WTI 321 crack spread 1m

But it seems there is only so far the US consumer can be pushed before demand declines and possibly demand destruction sets in. As prices have risen over time, US gasoline demand visibly came off. US drivers are just buying less of it these days.

Source: Barclays Capital

And that trend is starting to be reflected in the levels of gasoline inventories. According to the latest EIA data, US gasoline inventories are materially above the 5-year range for this time of the year. Given the warm US winter, this can not be blamed on the weather.

Source: JPMorgan

With recent spikes in gasoline prices, the consumer has been able to adjust the driving patterns as well invest in more fuel efficient vehicles.

NEW ENGLAND CABLE NEWS: MasterCard SpendingPulse says gasoline consumption across the United States has been on the decline every week for the past year, showing a total drop of 4.2 million gallons. That's a 3 percent decline.

Higher gas prices seem to be the main factor. AAA puts the average price of a gallon at $3.89 today. That's the highest ever for this time of year, and analysts say it could reach $4.25 by the end of April. That's prompting Americans to make fewer daily trips and staying closer to home when they take vacations.

But the man who oversees MasterCard SpendingPulse's weekly consumption report says that's not the only factor. John Gamel points to rising sales of fuel-efficient vehicles.

A recent survey by J.D. Power and Associates found new-vehicle owners rated good gas mileage higher than reliability, stylishness or a great deal in their car buying decisions.

This pattern, if continues, will cap crack spreads and limit profits for companies such as Valero (might be time to take profits). But as a whole, the concept of gasoline being an "inelastic" commodity in the US is starting to change. The consumer is now able to dial down the demand (only partially of course) when prices rise too far. In the long run the introduction of Compressed Natural Gas (CNG) as an alternative fuel for US transport, (initially as a diesel substitute for trucks) will create competition for US refiners.

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EIA's latest energy projections for the US

The EIA today released their abridged version of the 2012 Annual Energy Outlook. Here are three key highlights.

1. Net US consumption of "liquid fossil fuels" in the US is expected to stay almost unchanged through 2035. The domestic supply however is expected to grow, reducing the gap currently filled by imports from 49% in 2010 to 36% in 2035.

Source: EIA

This is not significantly different from their earlier forecasts.

2. The picture for natural gas however gets interesting.  This post in early December pointed out the risks to the downside of Natural gas.  As the weather stayed warm, that is in fact what happened.  Today we finally saw a reversal (an 8% pop) to what has been a relentless decline in price. EIA's forecast shows continuing growth in natural gas production in the US driven by shale gas. 

Source: EIA

The outcome of this growth in gas production has to involve significant US exports. As the chart below shows (hat tip Greg Merrill), liquifying natural gas and exporting it will allow companies to capture a massive spread differential.

EIA: The United States is projected to become a net exporter of liquefied natural gas (LNG) in 2016, a net pipeline exporter in 2025, and an overall net exporter of natural gas in 2021. The outlook reflects increased use of LNG in markets outside of North America, strong domestic natural gas production, reduced pipeline imports and increased pipeline exports, and relatively low natural gas prices in the United States compared to other global markets.

3. One surprising projection in the report is the continuing reliance on coal for power, given the vast amounts of cheap natural gas.  Natural gas usage to generate power is expected to increase by only 3%.  The chart below shows projected sources of electricity generation in the US, with coal usage dropping from 45% to 39%. The US should be able to have a bigger reduction, given the nasty effects of coal generated smog.

Source: EIA

Growth in renewables is expected to increase from 10% to 16%, still likely driven more by tax incentives rather than economics.

Enjoy!
2012 EIA projections

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A sober look at US natural gas

Looking back at a two year old post on natural gas called "Natural gas prices below zero?", it feels as though we are back to the same price dynamics. Price for the "nearby" Henry Hub contract hit new lows today at $3.317/mmBtu.

What is driving this price collapse? As before it is the usual suspects: limited storage, strong production (particularly in US shale), increasing reserves, and warm weather.  Let's take a quick look at the first three.

1. Storage: The chart below compares current storage usage versus the historical range based on where we in the seasonal cycle (inventory drops off in the winter and increases the rest of the year).  Just as in 2010 and 2009 we are at the top of the range and may go even higher if the weather in the NE & Midwest stays warm.

Source (EIA)

2. Production continues at rates significantly above historical levels. 

Source: EIA

This growth is driven by a rapid increase in shale gas production.  According to EIA, the US shale production increased 14-fold since 2000 and is now 22% of total US production.

Source: EIA

3. And estimated reserves in the US continue to increase.

Source: EIA

It is almost as though the US is becoming the Saudi Arabia of natural gas but with limited export capabilities. No real support for natural gas prices is expected to come until 2013. According to a Goldman report this support will come from moderation in production growth and environmental restrictions that will force conversion from coal burning to natural gas.

Goldman: 2013 shaping up as a transition year to a more balanced market We expect 2013 to be a transition year, with the market’s reliance on priceinduced responses (e.g. need for coal-to-gas substitution) diminishing as US shale gas production growth moderates, economic growth improves and looming increased environmental restrictions – notably, CSAPR Phase 2 and Maximum Achievable Control Technology (MACT) – further boost gas-fired generation at the expense of coal. On net, we expect less priceinduced coal-to-gas switching will be needed than in 2012, allowing prices to move higher, and are introducing a 2013 NYMEX natural gas price forecast of $4.25/mmBtu

Until then if the weather stays warm, there is no telling how low natural prices could drop.

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Fuel substitution: power plants switching to natural gas

A number of Sober Look readers have questioned the thesis of the earlier post that suggests that natural gas oversupply creates an overhang in distillates, thus pressuring crack spreads and ultimately capping oil prices. In particular some question the ability to switch between the two fuels.

Fuel switching is actually quite common at power plants, the biggest users of natural gas. Many modern power plants can switch between gas and fuel oil, and many can switch to coal as well.

EIA: A generating unit capable of burning more than one fossil fuel is referred to as a dual-fired unit. Some dual-fired units can only burn one fuel at a time (that is, the fuels are fired sequentially), while others can burn more than one fuel simultaneously (concurrent firing of different fuels). A sequentially fired unit generally uses one fossil fuel as its primary energy source, but can switch to a second fossil fuel as an alternate energy source.

In fact cheap natural gas has created an oversupply of coal as well.


source: EIA

Similarly distillates (fuel oil) inventories are building up, pressuring crack spreads:


source: EIA

Power plants and others are storing the more expensive fuel to be used in the event natural gas prices spike (because natural gas is difficult to store and not much storage is available). But for as long as gas prices remain depressed, buying gas in the spot market makes a great deal of sense for power producers, reducing the demand for other fuels.

During some periods in the past, natural gas was more expensive to burn, with coal and distillates being the preferred fuel. Natural gas at some plants was used to provide power during peak demand because gas generation could be brought online very quickly. But with the push toward a more environmentally friendly power generation, the switching capacity has increased significantly. The paper below provides an overview of both the switching capability and its use in practice. Since the paper was published, fuel switching technology has improved even more, allowing plants to respond to market prices and switch relatively quickly.

Despite a drop in inventories, crude oil price still constrained by oversupply of natural gas

The WTI crude oil futures curve has flattened substantially in the past month. It's an indication that the US crude reserves in storage may be on a decline and people are becoming more comfortable taking deliveries in the spot market.




The latest government data from EIA seems to support the declines in inventory, although crude stocks continue to be above the norm for this time of the year.




In particular what got the market's attention is a decline of crude stocks in the Midwest. It's not clear how real this is, but it tends to be a leading indicator for improvements in the US manufacturing activity.



This inventory decline and the weak dollar have pushed the spot price for crude higher, but it continues to be constrained by the tight crack spread (spread between refined products and crude). That makes refining far less profitable.




The overall demand for refined product is still weak, capping any significant further rally for crude. This is in particular pronounced in distillates - heating oil and jet fuel. Distillates inventory continues to rise to unprecedented levels in the US, in part driven by the oversupply in natural gas. Heating oil in many instances can be substituted with cheap natural gas, forcing more distillates to go into storage.



Unless the dollar weakens further or there is a miracle massive recovery in the US manufacturing sector, a significant crude rally is unlikely. And part of this constraint is emanating (at least in part) from depressed natural gas prices.