Coal, dry shale walls loom for US natgas rally

SOURCEReuters — U.S. natural gas futures have posted an impressive rally since briefly trading below $2 per million BTUs earlier this month, but the upside is increasingly limited by coal prices and the prospect of more gas from now unpopular dry shales. The more than 40 percent rally in natural gas prices has come even as major producers like Chesapeake Energy (CHK) have seemingly not cut output by as much as the market had hoped.

A string of better-than-expected weekly storage reports has, at least temporarily, allayed fears that producers would be forced to dump lots of unwanted gas on the spot market due to storage limitations. Increased switching away from coal by power utilities has further helped, propping up natural gas demand. Barclays Capital estimates that 7 billion cubic feet per day of natural gas has displaced coal from the U.S. power sector.

Some of this switching is due to utilities moving away from coal and into gas due to tougher environmental legislation, but the bulk of this incremental gas burn is due to economics. Gas is simply cheaper right now. That in turn has forced coal producers to cut output by 8 percent, according to BarCap.

So far, so good for gas. But here's where the problems for gas bulls mount. In the absence of a price for carbon emissions, coal competes directly with natural gas. So if U.S. natural gas prices rise to a level at which coal is economically competitive, utilities will probably cut gas consumption and switch back to coal.

The incentives to switch back to coal are considerable. Many U.S. utilities are sitting on growing coal inventories and are forced to keep buying the fuel under long-term take or pay contracts. GenOn, for instance, has declared force majeure on coal receipts due to a lack of storage space. With coal prices ticking lower due to the slump in utility demand, the upside to the gas rally gets closer.

Indeed logistical constraints, such as take-or-pay contracts and limited coal storage space, may well force utilities to resume coal burning even if the prices of gas and coal do not converge.

DRY SHALE WALL

The other, longer-term barrier to a natural gas price rally is the huge resources locked up in so-called dry shales. With the plunge in natural gas prices, producers have been curtailing output and drilling from basins like the Haynesville Shale, which yield little in the way of more valuable liquids But this move away from dry gas output has not eliminated this resource. If anything, the now unloved dry shales sit as a cap on the upside to gas prices.

A sustained rally in natural gas futures would give producers sitting on Haynesville acreage, for instance, a strong incentive to put it quickly into production. Indeed, it would likely spark a brief flurry of leasing as gas producers tried to grab any opportunity to boost output as prices rose.

The supply response is likely to be swift. After all, the shale gas industry has honed its techniques in recent years, cutting drilling and completion times and boosting well productivity. And many of these dry shales are among the best known structures, so compared with conventional natural gas, the exploration risk is minimal. Over the longer term gas should benefit from environmental rules that are squeezing coal out of the U.S. power market by forcing the closure of older coal-fired plants.

Gas prices might also get some benefit from supply discipline. Already big producers are coming under pressure from investors to rein in empire building and focus more on the bottom line. But for the most part these two supports are weak. Regulations can be overturned or watered down. Producer discipline is hard to maintain if attractive short-term profits loom. So ultimately gas faces a few years at least of relatively cheap prices.

It's a supply problem, after all. Gas has become much easier to produce in large quantities. Relief for producers can only come through new and bigger markets. But breaking into many markets, like transportation fuels or power generation, requires deeply undercutting the price of incumbent fuels. Give up the low cost of gas and new markets vanish.

By Robert Campbell - Reuters