2001-04

February 9, 2001

Economic Impact of Rising Natural Gas Prices

Natural gas prices have risen significantly in recent months, surpassing nearly all forecasts. In December, the spot price at the Henry Hub—the benchmark for U.S. natural gas prices—averaged $6.31 per million British Thermal Units (MMbtu), more than three times the average spot price one year earlier. In California, the run-up in prices has been even more dramatic, with daily spot prices averaging $15 per MMbtu and, at times, reaching $69 per MMbtu, a national historical high.

Increased costs for natural gas have begun to show through to consumers and businesses in the Twelfth District. Heating bills and electricity rates have risen for consumers in a number of District states, and additional increases are expected for the duration of the winter. For businesses, higher energy costs have constrained profits and prompted some District manufacturers and service providers to shut down until prices have settled back.

This Economic Letter examines some of the factors contributing to the recent surge in natural gas prices, paying particular attention to the increases in California, and discusses whether this is likely to be a short- or long-term problem. Having identified the major issues, the focus shifts to describing the effects that the price increases have had on producers and consumers in the District. The Letter concludes with a discussion of how rising natural gas prices are likely to affect economic growth in the West over the next year.

Recent trends in natural gas prices

Figure 1 compares the nation’s average monthly spot price for natural gas at the Henry Hub between January 1998 and December 2000 to the average range of annual wellhead prices from 1990-1999. The average annual wellhead price for natural gas between 1990 and 1999 was $1.90 per MMBtu. The average range, computed as plus or minus two standard deviations from the 1990-1999 average, was $1.40 to $2.40 per MMBtu.

Monthly spot prices began to exceed the 10-year average midway through 1999, hitting $3.05 per MMBtu in November 1999 and averaging $2.65 per MMBtu. However, the real run-up began in June of 2000, when natural gas prices broke through the $4.00 mark and began to increase at double-digit rates. By December 2000, prices were running above $6.00 per MMBtu, more than three times the price one year earlier. While analysts had predicted an increase in the price of natural gas in 2000, recent spikes surpassed almost all forecasts.

The run-up in gas prices has been most dramatic in California. On several days in December, spot prices for natural gas exceeded $50.00 per MMBtu, more than four times the national average. Daily spot prices in cash markets in other parts of the country hit comparable levels at times in December, but prices in California have been higher than the U.S. average for a sustained period of time. Figure 2 shows the spread between average spot prices in the California market and at the Henry Hub. Market prices for California are represented by two Northern (Malin, Oregon, and PG&E Citygate) pricing points and the average price at the three points in Southern California (Southern California border). Natural gas prices in California began to deviate noticeably in September, with average differences of around $1.00 per MMBtu. In December, the spread in prices in California and the U.S. average widened dramatically, surpassing $8.00 per MMBtu.

Why are natural gas prices rising?

Natural gas is bought and sold in an unregulated market, so, like other commodities, the price of natural gas at the wellhead is determined by supply and demand. The recent surge in prices is the result of rapid demand growth combined with limited increases in supply. Winter started earlier than usual this year in the East, Midwest, and Pacific Northwest, pushing temperatures well below normal in November and December. Industry analysts estimate that during the first six weeks of the traditional winter season, the average temperature has been 21% below the 10-year average and 35% colder than last year (Natural Gas Daily). This has meant unseasonably high heating demand throughout much of the U.S. At the same time, electricity deregulation and the general move toward cleaner burning fuels have resulted in considerable growth in electricity generation plants fired by natural gas. Data from the Department of Energy indicate that natural gas demand for electricity generation increased by about 12% between 1990 and 1999, making electricity generators the third largest user of natural gas, following industrial and residential customers. Finally, rapid and continuous economic expansion during the past ten years has boosted demand for natural gas among all users, especially industrial enterprises.

While demand has been increasing, supplies of natural gas have remained relatively stable. Like other commodities, natural gas supplies fluctuate with prices. Figure 3 shows the average number of rigs drilling for gas in the U.S. and the average spot price at the Henry Hub over the past three years. Low prices for natural gas in 1998 and part of 1999 resulted in significant reductions in gas drilling, as some existing wellheads shut down and new exploration and new drilling stalled. As prices began to rise in 1999, the number of rigs drilling for natural gas also increased, rising by about 70% between April 1999 (the trough of drilling activity) and December 1999. In 2000, the number of active rigs increased another 37%, rising to 854 rigs in December 2000.

Why are natural gas prices higher in California?

California is the largest consumer of natural gas in the West, accounting for about 70% of the natural gas delivered to western states. California produces only 15% of the natural gas it uses, importing the rest from other states (50%) and Canada (35%). The state imports natural gas via five major pipelines in Northern and Southern California. In addition to obtaining gas directly from the pipeline distribution network, companies in California rely on underground facilities to store natural gas inventories. About 70% of the storage goes to large gas distribution companies, primarily Southern California Gas and Pacific Gas and Electric. The remaining 30% is used by natural gas marketers, electric power generators, and large industrial end users. These storage facilities allow companies in the state to hedge against fluctuations in price and interruptions in distribution.

Because California has a large presence in the market, a diverse group of suppliers, and the capacity to store inventories, economic theory would predict that prices in California will equilibrate with those in surrounding states. The divergence in prices in recent months, therefore, suggests that some type of barrier—physical, regulatory, or market-based—has allowed natural gas sellers to obtain substantially higher prices. While it is difficult to pinpoint the exact cause of the relative run-up in price, pipelines into California are operating at or near capacity and stored supplies in the state are well below their five-year average, suggesting that daily natural gas demand is regularly outstripping the available supply.

As in other parts of the U.S., natural gas demand has been boosted by unseasonably cold winter weather, rapid growth in the use of natural gas fired electricity generation facilities, and general economic growth. At the same time, supplies of natural gas have been constrained by ongoing distributional problems related to the El Paso Pipeline explosion. The main channel in that network was slow to come back online and, during the worst part of the crisis, California drew down reserve supplies from storage, leaving levels lower than average entering the winter season. Adding to the difficulties of the demand and supply imbalance in California has been the deterioration of the financial position of two of California’s major buyers of natural gas, Pacific Gas and Electric and Southern California Edison. Both investor-owned utilities have defaulted on debt and missed payments for electricity delivered, motivating a number of providers of natural gas to raise their prices to these firms and, in some cases, to refuse to sell on credit.

Economic effects of rising natural gas prices in the District

Rapidly rising natural gas prices have become a major concern in many Twelfth District states, particularly with electricity prices also rising. Both producers and consumers in the District have experienced large jumps in costs, prompting some businesses to close temporarily and many consumers to reduce consumption and conserve.

For agricultural producers and many non-high-tech manufacturers, the price increases have been particularly difficult. Natural gas is an important component of production costs in agriculture: It is used for fuel to heat greenhouses and to run food processing machinery, and it is a major input in the manufacture of fertilizers and pesticides. As a result, many farmers in the District have experienced significant increases in costs, with some finding it more profitable to idle their production and/or fields than to produce under current conditions. Some District manufacturers are in a similar situation. Chemical makers, paper processors, brick producers, and food processors have decided to discontinue operations until natural gas prices improve. For manufacturers with forward contracts for natural gas, it is increasingly more profitable to resell this energy than to produce their products.

District residential consumers also are beginning to feel the effects of rising natural gas prices. Natural gas is the primary fuel for home heating in the West. Unseasonably cool weather combined with higher prices for natural gas has meant increases in heating bills of between 60% and 100%. Moreover, most major utilities in the District have warned customers that natural gas bills could increase even further in coming months. While the average residential consumer should be able to weather higher heating bills for three to four months, increased heating costs will depress households’ discretionary budgets and likely temper spending in other areas.

Although rising natural gas prices have hurt some producers and consumers in the Twelfth District, there is little evidence that rising costs have significantly slowed economic growth in the region. The lack of more widespread effects is not particularly surprising. On a per capita basis, western states consume less energy than the rest of the U.S. Natural gas accounts for only about one-quarter of all energy consumed in western states and, on average, expenditures on natural gas in District states amount to less than 1% of gross state product. Thus, even if prices remain high for most of the year, the impact on the economy, measured by its share of gross state product, will be less than the Asian financial crisis in 1997. Finally, unlike electricity markets, markets for natural gas are relatively unregulated and generally well functioning. Thus, capital spending on new production and distribution capacity for natural gas has responded quickly to price increases, and most analysts expect the supply and demand imbalances to be resolved by next winter.

Summary

Prices for natural gas have risen steadily and are currently well above historical levels. The recent surge in prices is due to rapid growth in demand over the past year, combined with limited growth in supply. Although certain businesses and consumers have experienced large jumps in costs, thus far the District economy has weathered the increases fairly well. Looking forward, given the relatively small role that natural gas expenditures play in the District economy and the limited time frame for the demand and supply imbalance, the increase in price should not derail the District’s expansion.

Mary Daly
Senior Economist

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

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