The natural gas industry in North America finds itself in an awkward combination of technical success and commercial stress. Well productivity is up, thanks to improvements in operating practices and technology such as horizontal drilling and multi-stage fracing. Well costs are declining as improved drilling technology drills wells in less time. Since 2006 gas consumption is up 15% while production is up more than 30%, increasing storage levels and providing greater supply security. Even more reassuring, proved reserves have been revised upward of 30% during the same time. From an operational perspective, this renaissance in North American natural gas production is a tremendous achievement.

The results are more mixed from a commercial perspective. Since late 2006, when horizontal drilling rigs surpassed 15% of all gas drilling rigs on their way to today’s 65% share, prices have tumbled by almost 80%, to less than $3 per MCF, in real terms touching the lows of the early 1990’s . Yet, the industry keeps producing more gas, with some analysts projecting large-scale physical shut-ins being required to balance the physical system . Some producers have managed to minimize exposure to low prices by hedging their production, but term prices also are in decline. The North American natural gas industry is producing itself into a commercially delicate situation.

While the supply side of the gas equation has garnered a lot of attention, the demand side has been relatively quiet with North American demand growing at around 2% per year since 2006. So even as gas prices have dropped by 80%, and future supply through proved reserves has increased substantially, growth in demand has been anemic . This is curious for a commodity with a continent-wide distribution network and established uses in residential, commercial, industrial, electric power generation, and even transportation. The fact that we are not increasing the use of gas in the face of ever-cheaper, bountiful, readily available supply is a form of market failure. The North American natural gas industry appears to have a marketing problem.

Our research suggests that at its core, the gas marketing problem is fundamentally about trust of supply and prices as potential consumers require stability on both points, which historically has not been the case. The U.S. natural gas market has been a rollercoaster over the past four decades, first through government influence providing the volatility, and later the industry doing its part. The potential high-impact industrial users of gas – whether electric utilities, chemical plants, or automobile manufacturers – generally have infrastructure based on a specific energy mix and would require switching or set-up costs to use more gas. The volatile price history of gas is a deterrent for these potential customers. Quoting from the Wall Street Journal:

There are no guarantees that natural gas will continue to be advantageous over the long term, so momentum ultimately could shift back to nuclear power. Natural-gas prices could spike, as they have before. Already, gas producers are drilling fewer wells because of low prices.

The industry recognizes a needed shift from the current status quo, specifically for electric utilities that have historically survived on excess, and interruptible, pipeline production to meet demand needs, but the direction is unknown. FERC, the U.S. Federal Energy Regulatory Commission, is considering increasing its involvement in aligning the gas and electric industries more efficiently. From Jeff Wright, Director of the Office of Energy Projects at FERC:

I think it is very likely that we will sit in the middle in terms of trying to -- I don't know if broker is the right word -- but come to some accommodation with the elements of both industries.

This type of thinking is certainly a step in the right direction, but based on the up and down results of previous regulatory involvement, government intervention may not necessarily represent the best option to reduce uncertainty. A nimble market solution is required to calm volatility fears as potential consumers may be intrigued by low gas prices, but they understandably are reluctant to jump.

The gas industry has developed solutions to long-term supply guarantees in the past, but carries baggage from that period. In the 1990s Enron (yes, we said it) tried to match long term gas customers, like independent power producers, with baskets of suppliers. It may have been a good idea, but the concept didn’t survive the downfall of the company and the idea of long-term, 20-year contracts, went dormant. Today, natural gas marketing organizations at producing companies more resemble trading desks than traditional marketers, with contracts lasting as short as a day or a week and focusing on near-term goals. This short-term commercial focus works for day-to-day operations, but there needs to be emphasis on creating markets for gas as opposed to simply responding to the now. The industry needs to put the “marketing” back into gas marketing.

Creating markets for North American natural gas would require some creativity and some risk. But the upside is tremendous, with the following industries providing a potentially large and diverse client base in both pre-existing and new market opportunities:

• Transportation (new market): cut a deal with a major automaker(s) to provide a minimum number of compressed natural gas (CNG) vehicles per year, in exchange for a commitment to equip a minimum number of branded retail outlets with CNG. Some of the largest producers have at least influence over chains of retail outlets carrying their brand. The recent announcement from GM and Chrysler concerning CNG-powered vehicles is helpful, as is UPS’ plan to use more vehicles powered by natural gas. Yet, the scale is still small relative to the cost-differential opportunity. Natural gas producers could be much more active in creating transportation markets for their product.

• Residential & Commercial (new market): to assist a switch of existing fuel oil users to natural gas, provide financing to homeowners so their net heating bill goes down immediately on the switch, and provide a 10-year supply guarantee to local distribution companies (LDC’s) to extend their networks. Much of the financing from this kind of arrangement likely could be sourced from third parties.

• Industrial (pre-existing): Provide term price guarantees for companies that reopen plants where production has moved from outside North America.

• Electric Utilities (pre-existing): These customers already have a significant amount of switchable capacity, and can move more quickly. While gas has been gaining share in this sector, it could be accelerated by increasing term commitments, to allow better planning by the utilities companies.

Our models suggest that gas demand could be at least 10% higher in aggregate with improved marketing. An extra 2 TCF of annual demand could relieve the storage situation in the US, which is currently 58% higher than historic levels and is projected to be at capacity well before the seasonal drawdown starts later this year. Without a market correction, there will be few options for where to move excess gas production.

The planned export-oriented liquefaction plants in British Columbia and along the Gulf Coast certainly fit the category of market creators as well. However, the inherent risk in exporting LNG to Asia from North America is greater than that associated with any of the ideas above, considering operational, competitive, domestic political, and geopolitical risks. A portfolio of laddered term agreements, backed by a portfolio of producing assets, would carry much less risk, by comparison.

The potential risk of long-term price guarantees also takes us back to the central question: Does the natural gas industry have the confidence in itself to produce as much as it says it can? The American Natural Gas Association (ANGA) has done an admirable job of promoting the industry and specifically the abundance of economically producible gas, but ANGA is not the counter-party on a 10-year supply agreement. Some producers are talking about long-term gas available at $4/MMBTU or less. In view of history, consumers reasonably are asking the industry to walk the walk.

Given large proved reserves and continuing improvements in technology, new regulation is likely the greatest risk to North American gas supply. It is possible that for long-term supply contracts, customers would accept a force majeure clause linked to the regulation of fracing. If the industry could get this clause written into long-term supply contracts, it would create a cadre of allies who also would oppose the destruction of gas supply through regulation. Then, the increased use of natural gas in new markets would in itself be one of the industry’s strongest defenses against crippling regulation.

The above arguments require a marketing mindset, which in many places has been overshadowed by a culture of short-term optimization through trading. The visionaries in this area, of which Boone Pickens is probably the most notable, are doing the industry a great service. But that is not a substitute for producing companies doing more of their own marketing. After the rollercoaster of these past four decades, customers want to talk to the guy with the product. It is not clear whether companies are prepared to have these conversations, much less actively initiate them.

The advances in production techniques, the embracing of new technology, and the development of new business models have all required ingenuity and daring. Those bets have paid off in creating a multi-generational supply of clean, domestic fuel, at historically reasonable price expectations. Companies may need to make a few more such bets to reap the value of what they have sown.

Figure 1

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Footnotes:

i James Crandell, Biliana Pehlivanova, Michael Zenker, “Natural Gas Kaleidoscope 2010 Census (for rigs)”, Barclays Capital Commodities Research, August 24, 2010
ii J. Marshall Adkins, John Freeman, et al, “Shift to Liquids Is Like a Monet: Up Close, It's Just a Big Mess for Gas Supply”, Raymond James U.S. Energy Report, February 6, 2012
iii U.S. Energy Information Administration, U.S. Department of Energy, 2012,
iv Rebecca Smith, “Cheap Natural Gas Unplugs U.S. Nuclear Power Revival,” The Wall Street Journal, March 15, 2012.

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