Newsletter Sign-up

Commodity Price Risk: Back to Where We Started

As the U.S. prepares to become an exporter of natural gas for the first time because of vast reserves, electricity users may well find pricing going up, not down.

Scenario: For more than a century, Ohio Valley Metals Inc. in Valley Gorge, Ohio, stood as a pillar of community strength -- literally.

It employed more than 1,000 people. For some families, the foundry put three generations through college. Wages were fair, work conditions were good, and the health and long-term benefits generous.

For decades after World War II, with the price of oil so cheap, it was easy for Ohio Valley to be generous. Nobody thought twice about taking a day off here and there, and everyone looked forward to the company picnic.

Safety and prevention procedures were up to date, and any OSHA citations -- five in the past 40 years -- were minor, and the steel plant regularly invested in technology upgrades and followed rigorous safety procedure.

Layoffs were almost unheard of. Any employee who left either did so because of ill health or left voluntarily. You could count on one hand the number of criminal incidents attributed to employees.

Ohio Valley's reputation was well deserved. It had built a name for itself supplying local and national markets with precision sheet metal for automobile, shipbuilding and U.S. military customers.

Ohio Valley Metals, with about $70 million in annual sales, powered its smelters using coal when the company was founded in 1906. Then it switched to oil. Even as a single source of power, oil at the time was cheap and plentiful.

Five years ago, the board and management voted to switch again from oil to natural gas. Valley Gorge, after all, was perched atop one of the largest shale gas deposits in North America, the Marcellus Shale formation stretching from New York state to West Virginia.

Switching from oil to natural gas was the most important capital project ever undertaken by the company.

"This $50 million capital investment is going to position us for the future," said Sands, in an interview with the Valley Gorge Times in 2004. "The oil crisis of the 1970s hit our customers hard, and it taught me a lesson about energy independence."

The oil crisis of 1973, which sent the price of oil from $20 a barrel to more than $100 literally overnight, also shook the steel industry to its core. Long-time manufacturing customers went bankrupt. Ohio Valley even scrambled to refinance to solve its liquidity crisis and stave off bankruptcy.

With lower natural gas prices, particularly with the exploitation of the Marcellus Shale, natural gas was suddenly far more competitive with oil, coal and renewable sources than it had ever been in the past. Sands often found himself thinking about the company's foresight with regard to switching to natural gas.

Even in the Great Recession of 2008, the company didn't need to resort to cost-control strategies like furloughs, wage freezes, high-deductible health plans, or even self-insurance, so long as prices remained this low -- under $3.00 per MMBtu.

Driving home, Sands would also dwell on articles in natural gas trade publications about how natural gas producers were looking to export markets. One piece in a major newspaper even led with a headline about how the U.S. was about to become a gas exporter for the first time in history

Because Ohio Valley Metals' clients were mainly domestic, news about export markets wasn't something that Sands had thought much about. The trade press was beginning to cover the issue of U.S. natural gas exports more frequently, and natural gas companies were even starting to build terminals in Louisiana with the idea of exporting the gas.

In Europe, gas buyers were routinely paying more than $8.00 per MMBtu. Some Asian markets were paying nearly twice that. Sands got to thinking, What if domestic U.S. prices were to rise, perhaps double or even triple? Natural gas companies would surely seek to get the highest price for their gas.

Sands wondered, Would Ohio Valley have to pay global prices, or would his company continue to benefit from low prices given the plentiful supply in the Marcellus Shale?

If Ohio Valley's energy costs jumped by 50 percent, the company might have to resort to layoffs, or radically reshape its benefits program. The 401(k) match might have to go, and the company might have to choose a high-deductible health plan. Sands began to think about self-insurance for the company's property/casualty program.

As he pulled into his driveway, Sands pondered the irony. How could Ohio Valley Metals be sitting on the edge of one of the largest natural gas deposits on earth, yet at the same time be socked with a double or triple-digit increase in the cost of energy?

Analysis: The United States is rapidly reaching an inflection point with regard to the import and export of natural gas, and as the U.S. prepares to export more natural gas, domestic consumers are likely to see prices rise.

While natural gas import volume has dropped export volume has more than doubled, going from 723.95 million cubic feet in 2006 to 1.50 billion cubic feet in 2011, according to the U.S. Energy Information Administration.

Average spot prices for natural gas on the New York Mercantile Exchange average $4.37 per million British thermal units (MMBtu) in 2010. Though that is up slightly from the prior year, "I don't know what it's going to take for natural gas to get any cheaper," said Marshall Nadel, a Dallas-based energy broker with Aon.

Prices in the U.S. are low, but in the next 20 years, the U.S. alone will need an estimated 233 GW of new energy generation, and at least 60 percent of that new capacity is expected to come from natural gas sources.

Developing economies like China and India are expected to put still more pressure on energy demands, and with regulators pressing for cleaner-burning fuels in an effort to wean ourselves from fossil fuels, natural gas prices are going to rise.

Natural gas imports by China alone exploded 67 percent between 2009 and 2010, driven by demand for electricity generation and air quality concerns, according to New Orleans-based energy consultant Charlotte Batson.

John McClane, president of a specialist insurer of renewable energy projects, said U.S. natural gas prices reaching $8 per MMBtu would not be "unreasonable," as U.S. gas producers take advantage of higher rates in global markets.

As demand surges, the average price of natural gas could range anywhere from $5.35 to $9.26 per MMBtu depending on how much gas can be recovered from shale deposits, according to E.I.A. estimates. Fetching higher prices for natural gas would enable gas producers to reinvest profits back into more efficient drilling. Natural gas investors will do well, too.

But for U.S. commercial and industrial users like auto makers or steel companies, the risk is that the cost of their electricity will go up, said McClane, president of New York-based GCube Insurance Services Inc., an underwriter of renewable energy risk. "The price of electricity by burning natural gas is going to be substantially higher," McClane said.

A spike in electricity prices could make it harder for a host of companies to meet their energy bills, forcing managers to lay off or furlough workers, or to cut back on the manufacturing of everything from cars to tractors to aircraft engines.

Remember the oil price spike of 1973? Hundreds of companies had to endure the pain of layoffs, cutbacks and restructurings. Might a spike in the price in natural gas likely have the same effect?

Batson, owner and principal of the energy and economic development consultancy Batson & Co., writes that recent mergers and acquisitions among pipeline owners proves the industry is serious about selling and exporting natural gas.

Kinder Morgan's $38 billion acquisition of El Paso Corp., owner of North America's largest natural gas pipeline network, last year is a "game-changer," Batson wrote. The deal, she wrote, will make it more efficient for the industry to supply higher-priced electricity markets in New York and Florida, and to send the gas to export terminals.

Cheniere Energy last year was the first company in 35 years to receive export approval for liquefied natural gas (LNG) from its Sabine Pass facility on the Texas-Louisiana border, and the company has signed contracts with Britain's BG Group Plc. and Spain's Gas Natural Fenosa to provide 7 million tons per year of liquefied natural gas over the next 20 years, Batson wrote.

Batson said these exports will be directed primarily to Asia where demand for LNG is strong, particularly in Japan and South Korea, and where prices are four times higher than in the United States. Japan and South Korea together imported 64 percent of global LNG last year, she said.

CYRIL TUOHY is managing editor of Risk & Insurance®. He can be reached at ctuohy@lrp.com.

April 13, 2012

Copyright 2012© LRP Publications