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How Much Longer Can Low U.S. Natural Gas Prices Last?

While the price of U.S. natural gas has rebounded significantly since hitting a low of under $2 per Mcf in spring 2012, the cleaner-burning fuel is still significantly cheaper than crude oil on an energy-equivalent basis. Many commentators have argued that the price disparity between the two fuels is unsustainable.

Paolo Scaroni, former chief executive of Italian oil major Eni, believes the price gap between oil and natural gas is an abnormality that will, over time, be corrected by market forces. "These two anomalies, once corrected, move us toward a world in which gas prices are higher and oil prices are lower," he told the Financial Times last year.

But what if he's wrong? What if lower gas prices simply reflect changing market dynamics -- a new normal of sorts? Well, that's exactly the finding of a report by IHS, a leading research and consulting firm.

A drilling site in Pennsylvania's Marcellus shale. Photo credit: Chesapeake Energy.

A sobering report for gas bulls
According to the report, titled "Fueling the Future with Natural Gas: Bringing it Home," the price of U.S. natural gas will remain relatively low and stable within a range of $4-$5 per Mcf for the next two decades. Meanwhile, the price of crude oil will remain three to four times higher on an energy-equivalent basis over that period, according to IHS.

In other words, the price disparity between the two fuels will continue for a long, long time. IHS' bold prediction is predicated upon continued strong growth in U.S. natural gas production, made possible by advances in horizontal drilling and hydraulic fracturing that have unlocked a veritable bounty of shale gas in formations such as Pennsylvania's Marcellus.

The report argues that gas can be produced economically from shale gas formations at a price as low as $4 per Mcf. With no shortage of U.S. gas reserves, operators can continue to "accommodate significant increases in demand without requiring a significantly higher price to elicit new supply," IHS said.

Why the report could be wrong
While the IHS report is extremely well researched, comprehensive, and insightful, I'm not sure if I agree with its conclusion. In my view, it may seriously underestimate increasing demand for gas, while overestimating supply growth.

On the demand side, three of the biggest drivers over the next several years are expected to be utilities, LNG exports, and energy-intensive U.S. concerns such as manufacturers and petrochemical operations. Combined, these sources could boost natural gas demand by 10 billion-17 billion cubic feet over the next five to seven years, according to estimates by Enterprise Products Partners.

The transportation sector is a wild card that could provide another big boost to total gas demand, though many experts believe that adoption of natural gas vehicles will remain limited through the rest of this decade. Still, given natural gas' relatively small carbon footprint, I suspect new policies and regulations should continue to support demand for gas at the expense of coal and other fuels.

Meanwhile, on the supply side, there are concerns that production from shale gas wells will decline at a much faster rate than output from conventional gas wells. According to estimates by Pete Stark, senior research director at IHS, the average flow from shale gas wells can plummet by as much as 75% in the first year of production. If shale wells' decline rates turn out to be higher than the industry expects, it could significantly constrain production growth.

The takeaway
It's hard -- and perhaps fruitless -- to try to predict where commodity prices are heading. But I still think there's a very strong possibility that natural gas demand from utilities, LNG exports, manufacturers, and perhaps even the transportation sector over the next five years could surprise to the upside, while supply growth could be weaker than expected. As such, I find it difficult to envision a scenario in which gas prices remain below $5 per Mcf through the rest of this decade.

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Arjun Sreekumar

Arjun is a value-oriented investor focusing primarily on the oil and gas sector, with an emphasis on E&Ps and integrated majors. He also occasionally writes about the US housing market and China’s economy.

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