Natural Gas and the Industrial Renaissance

Monday 02/17/14

     Last week stocks continued to march higher, recovering from the brief sell off in January. The recovery was interesting not just because it happened so quickly, but that it also happened despite continued weakness from most economic indicators. The industrial production report showed that manufacturing output in January fell 0.8% which was the worst drop since 2009. Weather was blamed by many economists, which makes sense because utility production rose 4.1% in the same period. However, the report also showed that manufacturing growth in the fourth quarter was not nearly as robust as it seemed. Revisions showed that fourth quarter manufacturing growth was 4.6% instead of 6.2%. Many have called the last few years of U.S. industrial growth a new manufacturing renaissance because the falling price of natural gas has been a major tailwind for manufacturers. However, in recent months the price of natural gas has risen dramatically and has become unstable.

     Natural gas is a mixture of gases, but is primarily made up of methane. It is used to heat homes, generate power, and in transportation. Natural gas has risen in popularity in recent years because of new technologies such as hydraulic fracturing and horizontal drilling, which made it possible to extract previously inaccessible gas. This video explains the process in detail. There are also many environmental consequences that can result from this process including possible groundwater contamination, the release of methane gas into the atmosphere and more.

     Because of the decline in natural gas prices it became more useful as a source of power generation. Utilities are price sensitive and will opt for whatever source is cheapest. However, natural gas prices bottomed in 2012 and have been rising ever since. As a result, utilities are switching back to coal. Low prices in natural gas were supposed to usher in a new era of cheap energy and drive America's recovery, but just because natural gas is abundant does not ensure that it will be cheap—at least not in the medium term.

     According to a recent report from the U.S. energy information administration, natural gas inventories fell to just 1,686 BcF (billion cubic feet). This is the lowest storage level for this time of year since 2004. Natural gas is still abundant and is not getting harder to extract, but it does run into transportation limitations. Owners of gas pipelines prefer to operate as close to 100% capacity as possible in order to maximize their profits. However, this is not always enough to meet demand especially during peak seasons. Problems are further exacerbated by unscheduled outages due to the weather or explosions.

     In recent weeks, natural gas prices have become extremely volatile, rising and falling as speculators pile in on the long and short side of natural gas futures based on changes in supply and the weather. This creates a problem for utilities who seek stability and low prices. Utilities can hedge their exposure to swings in natural gas prices, but that adds to the cost. As natural gas becomes more expensive, utilities will revert to using coal for electricity generation. The chart on the right shows how coal has recently been taking back market share from natural gas. This change threatens one of the primary drivers of an American manufacturing renaissance. In time, more pipelines will probably be constructed and this will put downward pressure on prices, but in the near future these limitations could be a major drag on manufacturing and the economy.
Index Closing Price Last Week YTD
SPY (S&P 500 ETF) 184.02 2.4% -0.36%
IWM (Russell 2000 ETF) 114.06 2.95% -1.13%
QQQ (Nasdaq 100 ETF) 89.81 2.96% 2.1%

Industrial Production

Source: Board of Governors of the Federal Reserve System

Natural Gas Prices

Source: EIA

Coal vs. Natural Gas

This chart shows how the long term trend has favored natural gas, but it also shows how coal has been reclaiming a share of electricity generation in recent years. Source: EIA