In the early 1970s, natural gas was in many ways an afterthought in the energy business, and there was no such thing as a “global natural gas market.” Today, however, it is as newsworthy when natural gas prices double or triple as when crude oil does. As the importance of natural gas to the world economy grows, it becomes more important to understand what drives the market. Understanding the fundamentals of natural gas supply and demand, and having a sense of the long-term trends in the market’s maturity, provide foundational context and indicators on where we are headed.

What we see as we look back over the last half-century of changes in the natural gas market are changes in both supply and demand. Demand has increased as awareness of the environmental cost of other fossil fuels, namely coal, has increased. The development of LNG technology has proven to be the sword that cuts the Gordian supply knot, by creating a single global market for LNG. Thanks to the worldwide maturity of LNG infrastructure, abnormally calm weather in the North Sea, a hot summer in eastern Asia, and historic levels of drought in Brazil all now factor into the supply and demand curves.

The globalization of supply

Natural gas has always been a superior fuel once you get it to the burner tip, whether in a municipal power plant or a kitchen stovetop burner. [1] Unlike coal, and to a greater degree than heating oil, the heat produced by the flame responds instantly and accurately to adjustment. It can be found in the ground in large quantities in forms that require much less processing does crude oil, and thanks to the simplicity of its molecular structure it is by far the cleanest-burning, least-climate-change-inducing of all fossil fuels.

Natural gas is, however, considerably harder to store and transport than solids such as coal, and liquids such as heating oil, for the simple reason that it is, well, a gas. It is hard to keep significant quantities of gas from escaping if one moves it using anything but a pipeline; even today, when it is not unusual to see natural gas prices above $5/mmBtu, one can find places (such as oil wells) where natural gas is simply burned off because there is no economical way to transport it to a pipeline. More importantly, it takes up far more space to store a given amount of energy in natural gas than it takes to store the same energy in refined products or crude oil or coal.

Crude oil, thanks to the relative ease of transportation across oceans, became a globalized industry decades ago. In the 1970s, however, there was effectively no way other than by pipeline to move natural gas from countries with rich supplies (such as Nigeria) to countries in need (such as Singapore). There was simply no way to put enough natural gas onto a single ship to make it worth the shipping costs, and there are no transoceanic natural gas pipelines.

The development of LNG (liquified natural gas) technology was the historical turning point. If you cool natural gas to -260˚ Fahrenheit, it becomes a liquid and shrinks by a factor of, ridiculously, 600:1. This means that if you take 3 billion cubic feet of natural gas and cool it down to 260˚ Fahrenheit, and if you have ships that can keep the natural no-longer-a-gas sufficiently cold indefinitely, you can fit all three billion of those cubic feet onto a single ship. Furthermore, when you deliver it to a customer who has an LNG storage facility that can keep the temperature below -260˚F, they can store it in a similarly small above-ground storage tank. When they finally do regasify it, it is already fully processed and ready to burn. It is expensive to build an LNG regasification plant, but not as expensive as it is to build an oil refinery. And for practical purposes, the entire world uses the same grade of LNG, whereas different grades of crude oil vary so widely in their characteristics that most of the world’s refineries can only refine a limited number of grades. The moment the transportation and storage problems are solved, in other words, natural gas leaps to the head of the fossil-fuel pack.

To give you a sense of the economic impact of the development of LNG technology: in the early part of this century, BG Group was the only company in the world that had a large fleet (thirty vessels or so) of special-purpose LNG ships. As a result, until the rest of the world’s natural gas players managed to build LNG ships and catch up, BG for several years made as much as a billion dollars in annual profits (not revenue, but profits) just from moving the natural gas from places where it was worth very little to places where it was worth a great deal indeed -- in 2012 the average Henry Hub price was $2.77/MMBtu[2] even though Japan and South Korea were paying something north of $17.00/MMBtu.[3] Now that worldwide LNG infrastructure has matured, the natural gas market has truly become a global market. Of course, the only reason that global supply matters is that global demand for natural gas is strong.

Two primary drivers of natural gas demand

Natural gas serves two fundamental purposes in today’s world. The first source of natural gas demand is the one that has been around the longest, and that is for use in powering heating furnaces and cooking stoves. The second is the generation of electrical power.

Natural gas as a source of heat

If you want a fire inside your house, either to warm the house or to cook with, then your main choices for centuries were wood and coal, and even into the 1960’s coal-burning ovens and stoves were not uncommon, at least in rural America. It is hard to keep a steady temperature with wood, and with both wood and coal it is easier to turn the heat up than to turn it down. Meanwhile, ever-widening awareness of the environmental consequences of burning coal has made it less and less desirable as a fuel.

Heating oil is more responsive to tweaking of thermostat settings, and burning heating oil damages the environment less than burning coal. However, coal comes out of the ground in a reasonably burnable state, while heating oil does not occur naturally. Heating oil must be refined out of crude oil, and refining is an expensive proposition. Still, much of the northeastern United States has historically used heating oil heavily in domestic furnaces, which is how heating oil got its name.

For heating purposes, natural gas is superior to other fossil fuels both in terms of flexibility and environmental impact. In other words, demand for heat is naturally demand for natural gas, if the supply problems are solved.

Natural gas as a source of power

Natural gas has been used for heat and cooking since the early 1900s, but in the latter half of the twentieth century, it began to be used more and more as a source of electrical power.

Renewable energy sources such as solar and wind and hydropower have been around literally for centuries, and we have for decades known how to turn them into electrical power. Until very recently, however, we have preferred to base our power grids primarily on fossil fuels, with a dash of nuclear fission, simply because of long-standing issues with power-grid reliability and stability.

A moment’s thought is all anyone needs to recognize that solar and wind power are not hyper-reliable and fully controllable. The sun doesn’t shine at night, or in bad weather, or even on cloudy days; and the wind notoriously “bloweth where it listeth,” and does so in gusts rather than at a conveniently steady velocity. This is why the deserts of southwestern North America have lots of solar farms and the island of Vancouver does not, and it is why wind farms like to live offshore or on mountaintops.

If electrical power were something that could be generated and then efficiently stored until needed, this unreliability would not be a major problem. Part of the trillion dollars that the European Union is spending on transitioning away from fossil fuels is allocated to the development of better battery technology and improved “power-to-x” efficiency, for precisely this reason.[4] But with current technology, power mostly needs to be generated as it is used, rather than as it happens to be convenient to generate it. At present, if a nation had built enough wind turbines and solar panels to provide 100% of its energy needs, but had no other sources that could generate the nation’s minimum energy requirements on demand, then on any calm and overcast day the lights would go out.

At first glance, hydroelectric generation does not have the unreliability issue that wind and solar have: intake gates can be raised and lowered at will to increase or decrease the rate of power generation, and the amount of power generated is smooth, without the sort of minute-to-minute random variations that can be produced by wind gusts or thick clouds’ occluding the sun. That is to say, on a daily basis, hydroelectrical power is not “stochastic.” For precisely this reason, in the twentieth century, while wind and solar power were avoided because of the stochastic chaos they caused on power grids, hydroelectrical power became a major source of power generation anywhere there were rivers enough to provide water, and hills enough to provide containment, for reservoirs.

So hydroelectrical power isn’t unreliable in the sense of providing uncontrollable daily fluctuations on the grid. The issue with hydroelectricity is drought. If there is no water left in the reservoir, then you might as well have a solar farm in the middle of the night or a wind farm in a dead calm.

Fossil fuels do not have the stochastic unreliability of solar and wind, nor the vulnerability to drought of hydro; therefore, most twentieth-century power grids were designed heavily around the fossil-fuel generation. There are lots of fossil fuels to choose from if one wants to build a power generator, and half a century ago natural gas was relatively unimportant as far as the power grid was concerned. Fossil-fueled power plants ran mostly on coal and heating oil. Today, however, when renewables fail, the primary consequence is that considerably more natural gas gets burned.[5] Why is that?

First, it is necessary to understand that a power grid’s power requirements are generally separated into the categories of baseload and peaking generation. The baseload is the constant level of power that is required 24/7; the peaking requirements cover the demand that rises and falls during the day as the sun comes up and goes down, as cold fronts and warm fronts move through a region, as people leave home for work and return at the end of the day, etc. Nuclear, coal, and heating oil all serve well for baseload generation, and only the growing awareness of environmental consequences has caused them to fall out of favor for this purpose.

For rapid response to fluctuating power demands, natural gas is preferred, simply because of the issue of “ramping.” Coal, for example, does not serve well as a compensator for minute-to-minute fluctuations in generation requirement, because one can’t simply dial up or down the level of heat produced by a coal furnace without a “ramping” period. If you want to increase output, you add coal to the fire, and the heat does not instantly increase. If you want to decrease the temperature of the fire, that takes even more time. Only the storage and transportation issues keep natural gas from being preferred to other fossil fuels for power generation, and the flexibility for peaking purposes is so superior that the cost of investing in expensive natural gas storage facilities and pipelines has been justified for decades for “peaker” generators. The baseload would be served by coal that could be stored in piles or heating oil that could be stored in tanks, while a smaller number of natural-gas-fired peakers would raise and lower their output minute by minute to keep the grid in balance, albeit at a price higher than the price of baseload generation.

The rise of renewables, by increasing the minute-to-minute variations in power on the grid, has just made these shock-absorbing peaker plants more important compared to baseload plants, and therefore has increased the importance of natural gas to the grid.

Thus, the importance of natural gas as a source of power has grown dramatically in the last few decades, as (a) the fossil-fuel share of baseload generation shrinks, (b) the importance of natural gas as a baseload fuel increases vis-à-vis coal and heating oil, and (c) the increasing instability of the grid due to solar and wind generation increases the importance of rapid-response natural gas generators for keeping the grid from failing.

Future trends

If we consider that the decision-makers in the modern world will continue to prioritize environmental concerns, then we can expect the following long-term trends to play out.

• For some years to come, we will be in a technologically interim period in which the percentage of power that is supplied by solar and wind continues to rise, but in which the technology to overcome the stochastic instability that solar and wind creates on power grids has still not matured. This means that we will see an increasing dependence on natural gas as the primary shock absorber, and an increasing correlation between power prices and natural gas prices. However, once battery and power-to-x technology mature enough to make solar and wind generation self-smoothing, the importance of natural gas to the power grid will begin to fade, and so will the correlation between short-term power and gas prices.
• We can expect to see continued increases in the share of power generation that is supplied by weather-based renewables such as solar, wind, and hydro, which will for the foreseeable future increase the degree to which the power supply can be significantly degraded by longer-term weather events such as drought or unusually calm or cloudy weather — events of which type have in fact played a significant role in the currently painful price of electricity throughout Europe. So long as nuclear generation remains unpopular, these weather-driven shortfalls will have to be covered by fossil-fuel generation, and the fossil fuel used will more and more be natural gas. We can therefore expect to see more weather-driven extreme price events in natural gas in the future, as the global natural gas market will more and more be the market most affected by weather-driven shortfalls in power generation.
• In the medium term, there is still no good substitute for fossil fuels on the horizon when it comes to heating homes and businesses— other than electricity, which simply pushes the problem back to the power generators, and therefore is still for the time being a fossil fuel issue with one layer of camouflage. And the more priority decision-makers place on environmental impact, the more public policy will drive a steady shift from other fossil fuels to natural gas. That is to say, for at least several years to come, the demand for natural gas as a source of heat will steadily trend upward, placing upward pressure on natural gas prices— particularly since using natural gas to heat homes and businesses reduces the supply of natural gas available to solve power generation shortages.

Conclusion

Natural gas has always been an outstanding fuel— if only you could get reliable supply to the burner tip. What we have seen in the past few decades is an explosion in supply, thanks in part to the development of a worldwide LNG market, coupled with an increase in demand as natural gas’s environmental superiority to other fossil fuels becomes more and more important, and as rapid-response natural gas “shock-absorber” generators become more and more critical to the reliability of the world’s power grids. The natural gas market is now global; it is now indispensable to the economies of the developed world; and it will continue to be so, at least until new renewable technologies solve the reliability issues and allow the complete abandonment of fossil fuels for power generation.

In a later blog post, we will discuss individual pricing factors in greater detail.

  [1] This is why cooking stoves throughout America use natural gas rather than heating oil wherever natural gas is available. It is also why my grandparents’ generation, which saw the invention of natural-gas-based domestic cooking stoves and heating furnaces, had a clichéd response to any dramatic improvement in any process: “Now we’re cookin’ with gas!”

[2] https://www.eia.gov/todayinenergy/detail.php?id=9490#:~:text=The%20average%20wholesale%20price%20for,at%20Henry%20Hub%20since%201999.

[3] At the time, Japanese LNG purchases were priced off of the Japanese Crude Cocktail, at formulas that treated an MMBtu of natural gas as being roughly equivalent to a bit more than 15% of a barrel of crude oil. In 2012, the average cost of a barrel of crude oil imported into Japan was $114.75 (https://en.wikipedia.org/wiki/Japan_Crude_Cocktail).

[4] “Power-to-x” refers to taking electrical energy during periods where there is more generation capacity than demand and converting it to some form of non-electrical potential energy. The classic example is the use, in Switzerland, of electrical power from low-cost generators to run water pumps overnight. The “storage” facility consists of two reservoirs with a power generator in between them. During the day, when power is in high demand, the water is allowed to flow from the upper reservoir to the lower one, through the power generator. During the wee hours, when power is in low demand, electrical pumps move the water from the lower reservoir back to the upper reservoir, converting the electrical energy into gravitational potential energy. At present, the major issue with all existing forms of “power-to-x” is that they are terribly inefficient, meaning that much of the power originally generated is wasted.

[5] Outside of France, that is. Years ago France shifted its power generation away from fossil fuels, but it shifted not to renewables, but to nuclear fission, which now provides 70% of France’s power generation. When renewables fail, France is apt to split more atoms.

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