Thursday, March 24, 2011

Nat Gas - Mar 24th

Natural Gas
March 24th, 2011

Japanese LNG demand

Natural gas has been one of the top performing commodities over the past month, rising 11.36 percent, and surpassed only by the high-flying silver and cotton markets.  One of the major drivers of the recent gains has been the expectation for increased LNG demand from Japan.  While there is little doubt that Japan will need to increase LNG (Liquefied Natural Gas) imports, this will have little or no effect on U.S. natural gas, especially in the short term.

A little bit of background on Japanese LNG demand.  Japan is the world’s biggest importer of natural gas, accounting for over 35 percent of global trade.  The Asian nation uses LNG for around 17 percent of its heating and power needs, a number that will certainly increase in light of decreased electrical supply from its damaged and disabled nuclear facilities.  Japan, lacking significant domestic supplies, relies heavily on imports from the Middle East and Asia to meet its needs.  A closer look at who sells Japan its LNG reveals that over 60 percent of its supplies come from Indonesia, Malaysia, and Australia, each of which represents roughly 20 percent.  By comparison, the United States supplies a mere 0.5 percent of Japanese LNG. 

Natural gas is not a global market like crude oil.  With the exception of LNG, it cannot be shipped easily over land and sea.  Natural gas markets develop locally, where pipelines connect producers and consumers.  The obvious example is North America, where a highly interconnected market exists.  North American prices however, are not clearly linked to those in Europe for example, as local natural gas cannot be easily transported via pipeline to overseas markets.  The recent development of the LNG market is changing things, but the U.S. is not an active participant.  While the U.S. does take in some LNG shipments, most of it is re-exported to other markets.  Last year LNG represented only 1.7 percent of U.S. supply.  Even if all of this was diverted to Japan, it would not have a huge effect on the domestic market, which is already oversupplied as a result of heavy investment in shale development. 

So, one might ask whether the U.S. will start exporting some of its excess gas to Japan?  The answer is maybe, but not anytime soon.  The Gulf of Mexico has LNG import terminals that could be converted to handle exports, but currently there are no LNG export terminals in the continental United States (there is one in Alaska that is likely to be closed due to insufficient volumes). 

In the end, the boost that the natural gas market has experienced due to the Japan story is overdone, or even outright misguided.  There are however other factors to consider.

US Nuclear Energy

The nuclear disaster in Japan has brought about a lot of scrutiny on U.S. nuclear energy producers.  Nuclear power provides around 20 percent of U.S. electricity.  On March 21st, Bill Borchardt of the U.S. Nuclear Regulatory Commission said the U.S. will conduct a 90-day safety review at the country’s 104 nuclear reactors.  This could cause some temporary disruptions to power supply and provide a brief increase in demand for natural gas-fired electrical production. 

U.S. Energy Mix – NG vs. Coal, NG vs. Oil

Coal fired power plants are the biggest provider of electricity in the United States, followed by natural gas fired power plants, which generated about 24 percent of the power supply last year.  Coal prices have risen steadily for the past year, with some indices showing an increase of nearly 75 percent.  Natural gas, on the other hand, has remained relatively flat to lower over this timeframe.  The best possible news that natural gas bulls can hope to hear is widespread switching from coal to natural gas by power plants. 

Crude oil has been on a tear recently, fueled in part by supportive fundamentals, and accelerated by tensions in the Middle East.  During this period of rising prices, natural gas has not participated; in fact prices have actually declined (until recently).  To illustrate the divergence in energy costs, I have included two charts below.  Crude oil contains 5.826 mmbtu per barrel, and the price of U.S. natural gas is quotes in dollars per mmbtu (Million British Thermal Units).  The first chart shows the price of crude oil and the natural gas energy equivalent price per barrel.  The second shows the ratio of crude to the energy equivalent cost of natural gas. 

Crude Oil and Barrel of Oil Equivalent Natural Gas
Courtesy of Bloomberg

Crude Oil : BOE NG
Courtesy of Bloomberg

The timing of the divergence seems to support the notion that the decline in natural gas is closely linked to the increase in shale development in recent years.  If the relationship between natural gas and crude oil were to return to historical norms, we could expect sharply higher natural gas, and/or much lower crude. 

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