Fundamentals in the energy markets are converging to increase the need for incremental gas storage.
The natural gas market is approaching a dramatic turning point. The fundamentals in the energy markets are converging to increase the need for incremental gas storage and the way that storage is used and valued by the customer community. Why is new storage needed? What will it take for new storage to be developed? What do customers need to commit to new storage projects? And how does the energy industry get all of these items reconciled?
The natural gas industry has always had a fascination with storage levels. Storage levels are used as a barometer for gas supply-and-demand trends. The industry traditionally has used the level of storage to predict seasonal gas utilization and prices. In some cases, storage levels have acted as a magic crystal ball, holding the secrets of near-term and future natural gas demand, supply, and pricing. However, the focus on how full storage levels are overlooks the more serious question: What do we do when fully utilized storage capacity is not enough to get us through the winter?
Traditionally, storage has been filled during the summer, when demand (in theory) on the pipelines and the cost of natural gas is lower. Gas is taken out of storage during the colder winter months to fill peak-day needs. With an increasing amount of electric generation being supplied by natural gas-creating growing summer demand on pipelines and more stable summer prices-the way the industry views and values storage is rapidly changing.
The Correlation Between Storage and Pricing
As we can see in Figure 1 (see p. 62), a lack of storage capacity can constrain the market's ability to adjust. The gas shortage in the winter of 2000-2001 was partly caused by the industry not maximizing storage in the previous season. The industry saw a dramatic price rise when it recognized there was not enough gas in storage. When the industry responded with increased production, it was amazing how fast the current storage infrastructure ran out of room; and how fast the price went down in response.
Gas Storage Demand
Natural gas is the most easily dispatchable fuel, and as such is gaining an increasing share of the more volatile market sectors. Recent conventional wisdom has suggested that gas-fired power generation will create a summer demand peak that tends to balance out the winter peak. Yet in many regions of the country, there will continue to be electricity demand peaks in the winter. The data in Figure 2 suggest that the imbalance between summer and winter demand is growing faster than the overall gas demand. The 2003 study by the National Petroleum Council (NPC) examined the monthly patterns of demand and supply, not just annual averages. The NPC study projects a steadily growing imbalance between average winter and average summer demand.
An analysis by EnCana Gas Storage also suggests that a trend already exists of increasing storage withdrawals per heating degree-day, meaning weather-sensitive demand is increasing. The NPC analysis suggests that natural gas supply will continue struggling to keep pace with natural gas demand overall. The higher gas prices associated with tighter gas supply might help by forcing out some of the base-load industrial demand; this is known as demand destruction.
Liquefied natural gas (LNG) will provide some supply, but it is not expected to provide enough supply to remedy this overall imbalance. However, it will either be base-loaded to help recover the huge infrastructure investments, or, if a spot market for LNG cargoes develops, LNG may be more plentiful in the summer, when there is less competition from the predominately northern-hemisphere worldwide LNG markets. Regardless, LNG would not seem to be a solution for market imbalances.
Gas is one of our most environmentally friendly fuels and will continue to be one of the quickest energy forms to dispatch. For a dramatic illustration of this point, consider the Northeast blackout of 2003, and the time it took for nuclear- and coal-fired plants to return to full capacity.
The higher gas prices the industry has seen over the last year may drive base-load demand to other energy sources, or it could lead to demand destruction. One might infer that a reduction in base-load demand would free up supply to help serve the peak demand days, but the truth remains that total demand is not forecasted to drop. If base-load demand is reduced, while overall demand grows, then clearly the need for balancing is increased.
Alternatives to gas storage for balancing the market are not attractive. Fuel-switching as a means of balancing gas markets is not a good alternative, since it is slow to respond, depends on conditions in other correlated energy markets, and has quite unpredictable costs that depend on the prices of other commodities. Fuel-switching is more likely to contribute to gas market imbalances, rather than solve them.
The Market Fundamentals
Let's take a different approach and apply simple economics to gas storage. Most storage capacity now uses naturally formed geologic pockets. What does Mother Nature have to say about the potential to add new, low-cost, high-performing storage capacity in ideal market locations? Keep dreaming. The best opportunities already have been largely developed, leaving mostly lower-quality but higher-cost prospects.
Working storage capacity in the United States slowed dramatically in the 1980s, after steady growth for 40 years. Gas consumption had peaked a decade earlier, and then fallen off.
Only recently has consumption surpassed the early 1970s peak. So storage development naturally slowed down in response to the leveling off of natural gas consumption. Regardless, a surplus of storage capacity existed by the 1980s, allowing for steadily increasing use of that capacity over the next few decades, without needing to add to the infrastructure.
Locating New Storage
The storage reservoirs in the best locations were developed during the industry's dramatic growth period from 1950 to the mid-1970s. Now that we need more storage capacity, where will it come from? Incremental storage increasingly will be in poorer quality reservoirs, farther from ideal locations, and therefore more costly to develop to provide new storage services. The next best storage reservoirs will take more wells, more compression, and more cushion gas to develop. Today, all of these components (especially cushion gas) cost considerably more than they used to. If the location of the new storage is not ideal, longer (and more costly) pipelines will be needed to connect storage facilities to markets. Looking at these fundamentals for developing new storage, it is easy to see why a number of storage development prospects have remained only prospects for years.
Why not develop incremental storage directly in the marketplace, where demand is critical under peak conditions? The answer is simple: economics. Most development opportunities in the key market areas are small, under 3.5 Bcf of capacity, and relatively isolated, making pipeline interconnections more costly. These areas do not provide the economies of scale that larger storage facilities do. Very few projects can survive under such economic conditions.
The Storage Solution
We know that more storage is needed. We also know that not many new, flexible storage projects are making it to the finish line. So what will spur storage development? Let's look at this from two perspectives, the customer and the developer.
As you think about what impact the fundamentals discussed above will have on gas markets, think about how that will impact your business. Will the cost of gas during seasonal periods of scarcity make your industrial process, your end users, or power generation facility uncompetitive? Will the customers on your pipeline or distribution system have to curtail gas usage, causing you lost throughput? As a producer, won't you be dismayed by lost sales opportunities, and the impact on your netback of a less efficient use of existing infrastructure?
To protect your business against such scenarios, consider increasing your use of storage services. You may be positioning yourself to avoid crises that catch your competitors. And you will be encouraging the development of more infrastructure which, over time, may catch up again with the market's balancing requirements.
As a potential customer of storage service, this is the time to make your wish list. Ask yourself the following questions:
- Do I need storage to cover 20 to 30 days of peak in the winter or summer?
- Do I need storage to help me augment a larger part of my overall gas portfolio?
- Do I want storage to help insure against price spikes and to take advantage of selling opportunities when they present themselves?
- Do I want a storage service to help me minimize disruptions at my industrial plant?
- Do I want all of these things rolled up in a storage service?
With the flexibilities available in contracting for storage services today, storage customers should be able to negotiate any and all of these things. You can also demand a shorter-term contract in the 3- to 5-year range.
But avoid inflexible storage service. Find a storage developer that can build a contract that reflects the actual needs of your company. You may need more than one contract to fit your needs most economically. Look at your storage contract and the tariff that governs your storage service. Will your storage provider offer liquidated damages if he does not deliver? The ultimate test of faith is if your storage provider offers liquidated damages in its storage services tariff if he does not deliver. If this is offered to you as a consumer, then you have a very reliable storage service.
What Storage Developers Want
Most successful storage developers have the ability to take on some level of risk to successfully see a project to completion, but this risk has to be encouraged by some reasonable customer commitment and support from the regulators. Independent storage developers have added the most new capacity in recent years and are likely to continue doing so. By definition, the independents are not affiliated with interstate pipelines or local distribution utilities, and thus they typically do not have market power, or other conflicts of interest. With an entrepreneurial spirit and a focus on storage, they often are better equipped to deliver new projects than an integrated utility company. Independents seek lighter-handed regulation, which has been successful in markets like California and was recently acknowledged by the Federal Energy Regulatory Commission in its Affiliate Rules Order 2004A. The marketplace generally will benefit from such usage, as the aggressive use of storage (no matter by whom) will serve to dampen volatility in the gas markets.
Primarily, storage developers need creditworthy customers to sign up for reasonable term contracts from 3 to 5 years. Assuming a development opportunity can be found in the market of need, it takes 3 to 5 years to plan, permit, and construct a new natural gas storage facility. Storage developers require firm commitments by customers well in advance of the service startup in order to undertake the financial risks of development. Incentives are often available to customers that commit early and support development.
Customers need to think outside of the box to find the right storage for their business model and the right developer to deliver economical and reliable new storage projects to market. If we can get the right forces together, new storage projects will be developed and will help the energy marketplace to be more reliable and affordable.
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