Gas Pains

July 2, 2003
By Charles A. Kohlhaas 

The shortage of gas in the United States is now officially recognized.  It has been legitimized by Alan Greenspan in testimony before the House Energy and Commerce Committee, reported by The New York Times and the Wall Street Journal, and advanced to an editorial subject in the Wall Street Journal; all in a fortnight.   

This is a problem that has been building for years, however, and will have deep and profound consequences for the American economy and, consequently, political alignments.  Because natural gas is clean-burning and economical, it is the primary fuel for heating new homes and commercial developments and new facilities to generate electricity.  Demand is increasing and production is declining.  Shortages are predicted to have severe negative consequences for the American economy.  At the same time, political and market forces have limited the supply of natural gas and severely constrained development of new supplies.  

A gas shortage developed in the early 1970s at about the same time as the Arab embargo on oil.  The two combined for what was called the Energy Crisis and caused major political reaction.  

In response to the gas shortage of the 1970s, government provided various price incentives in long-term contracts for pipelines and producers.  Large supplies were developed and eventually surplus capacity was available.  This surplus lowered prices for marginal customers who purchased gas on the spot market.  The price discrepancy led to the abrogation of the long-term contracts and repudiation of the price incentives.  Gas contracts started trading on the NYMEX.  Marginal pricing, in which the price of small marginal amounts determines the price of all the gas (or oil, or any commodity traded in such a manner), became the pricing system for gas and oil.   

Marginal pricing led the way down for prices for all gas to sub-economical levels at the same time oil prices also collapsed.  Producers bankrupted on a large scale and repudiated their debt.  In the late 1980’s the industry imploded by about 80 percent; widespread layoffs collapsed real-estate markets from Texas through Oklahoma, Kansas, New Mexico, and Colorado to Wyoming and Montana.  Homes could be bought by assuming payments.  At one point, Denver had 17 “see-through” major office buildings downtown.  Banks failed and when the chain of debt repudiation extended to home mortgages, savings and loans followed.  Commercial real estate and home equities were destroyed.  

But the rest of the country neither noticed nor cared.  With cheap gas and oil, the national economy continued to grow.  Real estate values surged on both coasts; the increase of employment in manufacturing was followed by the tech boom of the late 1990s.   

Concurrently, the growth of the environmental movement in the 1970s began raising questions about pollution and the effect of any type of industrial activity, including oil and gas development, on the environment.  The effect of ever-increasing environmental restrictions on oil and gas operations through the 1990s was not noticed; a surplus of supply was available and more development was not needed.    

That supply surplus is now gone, however, and the outlook is not good.  Prices are still determined by trading contracts on the NYMEX and other short-term trading mechanisms.  Marginal pricing is now increasing the price of all gas just as it decreased it in the 1980s.  Severe environmental and other regulatory constraints prevent development of new supplies in most of the country.  Drilling is prohibited offshore the West Coast, the East Coast, the North Coast, and most of the South Coast.  Only offshore Texas and Louisiana can be developed and those areas are so picked over that new wells lose over 50 percent of their productive capacity in the first year and another 50 percent in the second before they go into a steady prolonged decline.   

In Wyoming, development of gas fields is prevented during most of the year by considerations of sage grouse mating and nesting, mountain plover mating and nesting, prairie dog activities, big-game mating, vacation periods (we cannot let a vacationer see a drilling rig; that might have a negative impact on the vacation experience) and various other considerations.  The period available for drilling is from 1 to 3 months out of the year.    

Operators with large lease positions will require decades to develop any significant amount of supply with these restrictions – that is, if they can get a permit to drill and find a drilling rig.  The federal administrative bureaucracies have developed an anti-drilling bias; drilling permits that used to require a few days now require months.  The average length of time to acquire a federal drilling permit from the Bureau of Land Management increased by 60 percent from 2001 to 2002.  Drilling contractors are reluctant to invest millions building drilling rigs and training crews that will be busy only for 1 to 3 months of the year and subject to an uncertain permitting process.   

Those in the industry who saw the repudiation of contracts and price incentives in the 1980s have little faith in government incentives or guarantees.  This skepticism is reinforced by increased bureaucratic opposition, proposed “Energy Bills” which are actually farm-relief programs mandating corn alcohol fuels, and drilling bans on leases after operators have paid significant acquisition fees.  Government has lost credibility.  The industry is generally relieved when an “Energy Bill” does not pass.         

Other sources of energy are often proposed as a solution.  “Renewable energy” is a chimera; it is generally more expensive and has greater environmental impact than conventional gas development.  The recent outcry against windmills placed offshore in Massachusetts, (and this a “renewable clean energy” offshore, one of our most liberal states) demonstrates that such alternatives will not be replacing gas as a fuel in the near future.  Nuclear power is one of the cleanest, and safest, electricity sources.  It causes severe environmental and political emotional reactions, however, and is not politically acceptable, mostly for the wrong reasons.    

Mr. Greenspan suggested that imports of liquefied natural gas (LNG) must be increased to alleviate the problem.  Imports of gas require contracting with foreign governments for field development and infrastructure.  The fields must then be developed and produced.  The gas must be liquefied for transport to the United States where re-gasification is necessary at or near the point of import.  Large long-term investment will be required, mostly in unfriendly and unstable places.  Such investment will require long-term contracts at reliable prices; marginal pricing will not be attractive.  On the receiving end, the United States currently has only four gasification plants and the thought of permitting any new ones is enough to give nightmares to any investor. 

With increasing gas demand and a lack of supply, marginal pricing could be expected to lead the prices of gas ever higher.  Should we expect prices rising to $10 per million BTU?  $15? $20?   Sustained prices at these levels would have a devastating effect on residential and commercial customers, industry, agriculture, and have a major widespread effect on our economy.  It seems more likely, however, that although we may have spikes to these price levels, they will not be sustained.  Some analyses show prices will level off at an average in the $3 to $4 range.  Instead of extremely high prices across the entire economy, prices will be held at these moderate levels by selective demand destruction, a far more subtle and insidious result of gas shortages because the effects will be more gradual.   

Electric generation plants and commercial and residential customers have little flexibility with regard to switching to other fuels or in changing location.  The burden of adjusting to shortages of cheap natural gas therefore will fall on basic industries.  Many industries cannot operate competitively in the world economy with high gas prices.  Those industries will close factories, lay off workers, and either go out of business or move to other countries.  In either case, unemployment will increase in the Unite States.  If jobs are lost throughout the country we can expect the same results nationwide that were experienced in the center of the country in the 1980s.  Widespread corporate bankruptcy, layoffs, real estate market collapse, equity loss, mortgage and debt repudiation, and widespread bank failures.  “Energy Bills” such as those proposed will not stop this process.  

Wall Street has noted that this process has already started and is identifying industries that will be driven out of the country: Fertilizers, chemicals, refining, food, paper, steel and various specialty manufacturing.  Shares of gas producers are selectively recommended on the basis of whether they are successfully re-deploying capital outside the United States. 

The political system must answer a simple question for its constituents: How many and whose jobs shall we sacrifice and family savings shall we destroy on behalf of sage grouse and prairie dogs?  I have observed that prairie dogs thrive in the Denver metropolitan area, in some cases within a few feet of major thoroughfares carrying large amounts of traffic.  It is difficult to believe drilling operations in the summer in Wyoming will disturb them much.  The environmental movement has had an unchecked free run for 30 years with no concern for the consequences of its actions.  It is now time to pay the bill; it must be decided who is going to pay and how much.  The natural, commendable, and legitimate concerns of the American people regarding pollution, wildlife habitat, and preserving our natural environment have been perverted to a system with little regard for the economic impact on the people themselves.  A balance must be established between cost and benefit.   

In addition, the marginal pricing system, which works so well to take prices to a minimum during periods of oversupply, but which creates volatility and leads prices higher without attracting investment in periods of shortage must be modified with a reliable long-term pricing and supply structure.  This will be necessary to develop foreign sources of supply and the infrastructure for importing gas as LNG; no less should be available for our own citizens for development of domestic supplies.

Dr. Charles A. Kohlhaas is a former Professor of Petroleum Engineering at the Colorado School of Mines and has worked for, founded, managed, and consulted for major and independent companies in the international oil and gas industry.  He has written on questions relating to oil for previous issues of In the National Interest.