Over the past decade, there has been a dramatic increase in the price of natural gas. Wellhead prices nationally more than tripled, going from $1.70 per thousand cubic feet (mcf) in October 1994 to $5.45 per mcf in October 2004. Industrial and commercial prices in Ohio nearly doubled, increasing from $5.63 to more than $9 per mcf during the same period.
What’s driving this upsurge in natural gas prices? That depends on who you ask.
The primary suspect is an increased tightness in the gas market. U.S. production over the last decade has remained relatively flat, while decline rates for new production have increased substantially. Accordingly, it’s becoming more difficult to maintain current levels of domestic production.
At the same time, demand for natural gas has grown at roughly 2 percent per year. The majority of that increased demand has occurred in the summer as gas-fired electric generation has increased. In 1994, for example, monthly gas demand followed an expected pattern — higher in winter months and lower in summer months.
While subsequent years have followed this pattern, trends are starting to favor an increase in summer consumption. This impacts our ability to fill gas storage for the winter.
Industry analysts credit this tension between domestic supply and demand as the factor moving prices to existing levels and increasing price volatility. Natural gas prices are now more sensitive to changes in demand. This is reflected in the price movements seen in response to weather and natural gas storage reporting.
The secondary suspect for today’s high natural gas prices, however, is the participation by hedge funds in the NYMEX futures market. A few market participants have expressed a concern that price volatility can be attributed to hedge fund trading in the energy markets, as these funds have no intention of taking physical delivery. That concern was recently reviewed by two regulatory agencies overseeing the market and found to be unsubstantiated.
The Commodity Futures Trading Commission (CFTC) observed that nondelivery of the commodity — i.e., natural gas — is the norm in the futures market, asserting that less than 1 percent of all such futures trading results in delivery.
The purpose of the potential delivery option is to ensure that the futures price converges to the commodity price in the physical market. Accordingly, speculative trading helps provide the necessary liquidity to be an efficient market. The CFTC concluded, therefore, that it “does not believe that hedge funds are the major source of price volatility in the natural gas market [at this time].”
This conclusion is shared by the Federal Energy Regulatory Commission (FERC), which observed that, while speculative trading may have an impact on short-term price volatility, recent volumes (about 9 percent of the trades) have been insufficient to have caused much of the current price movement.
Notably, the NYMEX just released a report addressing this issue. It concluded, “In short, it appears that Hedge Funds have been unfairly maligned by certain quarters who are seeking simple answers to the problem of substantial price volatility in energy markets, simple answers that are not supported by the available evidence.”
That returns us to our primary suspect — the current tightness in the natural gas market. And it doesn’t look like that’s going to change any time soon. Natural gas, with its relative environmental benefits, has become a critical and growing component of our nation’s energy consumption.
With domestic supplies unable to meet growing demand, it is unlikely that prices for natural gas will return to the levels experienced in the mid-1990s.
Gregory D. Russell is a partner in the Energy and Environmental practice group of Vorys, Sater, Seymour and Pease LLP, where he specializes in natural resources law. Russell represents producers in business and litigation matters relating to the exploration, production, transportation and marketing of oil and natural gas. His practice also involves representing clients before federal and state regulatory agencies on natural gas and electric matters, including matters before the Federal Energy Regulatory Commission and State Public Utility Commissions. Reach him at (614) 464-5468 or [email protected].
