FRBSF Economic Letter
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 this newsletter 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. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
