Tuesday, January 31, 2012

"Shale gas glut, but won’t last? The underlying model" (CHK; RRC)

Natural Gas futures are down 7% at 2.522. They will be under $2.00 by June as storage capacity tops off and production goes directly into the spot market.
Chesapeake is down 2% at $21.26, Range is down 1.39% at $56.96.
From Knowledge Problem:
Ken Silverstein has a good article in Forbes on the business prospects for shale gas developers (and I’m glad to see him there, having followed his work for a very long time). Since he asks in the title whether low shale gas prices are a mirage, I think it’s useful to go through the underlying economic analysis that’s embedded in his article. Note: if you are a principles student, this is a good exercise for you, because there will be a lot of shifting of supply and demand curves.

We start with the current boom in shale gas production, the consequence of technological change — horizontal drilling makes gas deposits available that were not with conventional technology. How do we model technological change? As an outward shift/increase in the supply of natural gas; at every price the quantity supplied is now greater, at every quantity the supplier’s marginal cost has fallen. For a given demand in the natural gas market, moving along the demand curve toward the new equilibrium means that price falls and quantity of gas sold and consumed rises. That’s a good model of where we are now.

But this equilibrium is unlikely to persist. Why? Because people don’t consume natural gas in isolation; we make decisions at the margin about when to substitute natural gas consumption for other fuel consumption, depending on the relative prices of those fuels. Even assuming all other things equal (a strong assumption), the falling price of natural gas will make the relative price of coal (Pcoal/Pnatgas) go up. Natural gas has become cheaper relative to coal, and at the margin consumers will substitute out of coal and into natural gas, even barring any other changes. We model this effect as a decrease in demand for coal, a leftward shift in the demand curve. For a given supply of coal, that means a lower price of coal (bringing their relative prices back into some balance that I won’t bore you with here) and lower quantities of coal consumed. In the short run that happens by substitution where it’s easiest, in industries using technologies (engines, turbines, smelters, etc.) where it’s relatively easier to switch between fuels.

Note also that regulatory changes, such as environmental regulations to reduce greenhouse gas emissions, will exacerbate the substitution out of coal, and shift the demand for coal even further to the left.
Another important factor in a dynamic economy is time, and the fact that over time, by adapting to these changes, people create new changes....MORE