Figure 2: US Power Generation by Energy Source (Source: EIA)
Natural gas pricing mechanism in a constant state of update
With all these fast-pacing changes and adjustments, it is not surprising that the natural gas pricing mechanism has been through a series of alterations and is yet to be settled down.
First of all, there is an inherited logical loop in the price setting mechanism in relation to supply. "Proven" reserves, which are most frequently used for defining the basic supply, according to some definitions have to be not only technically recoverable, but also economically profitable. Economical profitability has to do with the regulatory and contractual conditions as well as market prices. From this perspective, natural gas price, being impacted by supply-demand curves, at the same time becomes a parameter affecting the supply estimates.
Further to that, it was not so long ago when oil was acting as the generally accepted underlying commodity for the natural gas pricing.
Probably the easiest explanation of this relation is that oil and natural gas both originate from the same source, hydrocarbon reservoirs. In majority of cases, natural gas is found compressed on the top of crude oil horizon. As the economics of both these natural resources are bound together, it was quite logical to link their prices. Oil, easily transported across the globe and remaining the primary energy source in a multitude of industrial applications, has developed a universal marketability or liquidity. Unlike oil, transportation of natural gas has been, at least until recently, dependent on a network of pipelines; this made it a local commodity. With such limitations, it seemed reasonable to link the natural gas contracts' pricing algorithms to prevailing oil prices.
At times, a weighted average of crude oil or its products (gasoil, gasoline, naphtha, fuel oil, etc.) was used for natural gas pricing. Natural gas analysis and price projections were linked to the macroeconomic models of the oil markets. Those models usually incorporated features of oil supply, such as exploration, extraction and depletion, and oil demand. The general expectations for a consistent gas price increase were aligned with the projected decline in oil supply based on the theory of “peak oil”. For a long time, those models worked without fail; risk management departments used futures contracts to hedge their positions and effectively offset risks. Then something happened. Previously made long-term projections turned out much higher than the actual natural gas prices. It meant that the forecasting models started failing in their reflection of the new reality.
The new reality included growth in shale production that brought in an influx of this resource. Expansion of LNG infrastructure worldwide offerred completely new opportunity to these additional volumes. It has effectively turned natural gas into a global commodity. With open markets gaining more momentum, more pricing hubs have been set up around the world with some of them gaining recognition of global benchmarks. As a result, more contracts get priced to the natural gas markets while oil-linked trades are slowing becoming a fact from the past. The new natural gas pricing models start incorporating supply and demand dynamics of the natural gas itself, with more attention given to its global nature.
Long-term vs. short-term natural gas projections
Like any other commodity, which is used to support the immediate human needs, there are few time horizons for settling natural gas prices. Longer terms (mid-term and long-term) are somewhat similar in their approach. Those trades are executed predominately to serve the expected demand levels and risk management purposes. Short-term trades mainly balance the current fluctuations in demand. Accordingly, price projection mechanisms differ for short-term versus long-term time horizons. Short-term insight has a deeper look into behaviour of all market trading parties reflected in technical parameters, or technicals. Balance between fundamental factors, while present in the both approaches, has a much heavier impact in long-term forecasts. Fundamentals usually carry a much more profound bearing towards expectations for changes in the fossil fuel recovery and adjustments to its utilization rate by different classes of customers. These changes are driven by different factors. Some of these factors can be referred to as "classical drivers" while others have been added to the analytical plate recently, playing a role of "disruptors". Currently, the clean and environmental agenda is the most dominating factor influencing the natural gas movements; it has its impact on the both timelines.
There are several drivers currently on the demand and supply sides that are likely to keep counter pressure on prices over longer terms. Figure 3: Drivers of the Long-Term Natural Gas Price Projections summarizes these factors.