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FERC Says 'No Physical Explanation' for $13 Gas Prices in 2008

Increased natural gas trading by primarily institutional investors and a rise in commodity prices globally -- combined with modest tightening in gas supply-demand balance in the first half of 2008 -- contributed to the sharp rise in both spot and futures gas prices last year, FERC said in its "State of the Markets Report" for 2008.

The Federal Energy Regulatory Commission's (FERC) Division of Energy Market Oversight (EMO), which prepared the report, believes that the financial fundamentals played more of a part in the gyrations in futures prices and the Henry Hub spot price in 2008, which rose to $13.32/Mcf last July and crashed at $5.71/Mcf by year-end. There was no "physical explanation" for spot prices to climb to the $13/Mcf range, according to the full report, which was released last Wednesday. FERC issued a summary version last April (see NGI, April 20).

"While physical market fundamentals, particularly relatively low gas in storage, explain part of the rise for both futures and spot gas prices, there's no physical explanation for prices in the $13 range," the report said.

"However, the rise in gas prices did coincide with a global increase in many commodity prices, which occurred as large pools of capital flowed into various financial instruments, turning commodities such as natural gas into investment vehicles. [The EMO] staff believes that it was the upward pressure of financial fundamentals on top of a modest tightening of the supply-and-demand balance for gas in the first half [of] 2008 that explains the path of natural gas prices during the year," the report said.

"The past few years have seen a large influx of passive investments, primarily from institutional investors, into commodities in general and natural gas in particular through vehicles such as exchange traded funds," it noted. In May 2008 Michael Masters, portfolio manager for Masters Capital Management LLC, told Congress that assets allocated to commodity index trading strategies rose to $260 billion by March 2008 from $13 billion at the end of 2003.

He also reported that natural gas purchases by passive investors in commodity index funds increased to more than 2,263 Bcf by the first quarter of 2008 from 331 Bcf at the start of 2003.

"Passive investment in commodities is not manipulation, nor is it necessarily bad for market outcomes. Passive investors and active speculators can enhance price signals to producers and consumers that energy markets are tight by bidding up prices, in effect magnifying the impact on prices of underlying fundamentals. Such a phenomenon likely contributed to the rapid rise in gas prices and other commodities during the first half of 2008 and the subsequent collapse of commodity prices during the second half of the year," the FERC report said.

In addition, "we believe that some of the increase in prices was the result of market perceptions and technical trading strategies. These technical trading strategies include the tendency of commodity traders to trade in a manner that is consistent with the prevailing price movement. Thus, some technical traders buy as the price is moving up and sell as the price is moving down," it noted.

The strategies result in the accumulation of long positions as prices increase and the accumulation of short positions when prices fall. The report said the average monthly open interest in the natural gas prompt month climbed 109% to 106,000 contracts in the summer of 2008 from 50,759 contracts in 2006, as average monthly gas prompt prices climbed 38% to $12.78/Mcf in June 2008 from $9.23/Mcf in 2006. And as prompt month gas prices fell to $5.74/Mcf at the end of 2008, interest fell 25%, according to FERC.

The markets report said there were no major disruptions to cumulative supply during the first half of 2008 that would explain the increase in prices. It estimated that total gas supply, including pipeline imports from Canada and liquefied natural gas, increased between 1.3% and 3% during the first half of the year. At the same time cumulative gas demand through June 2008 rose between 2% and 3.6% relative to 2007, it said.

"While the growth in consumption during the first half of 2008 could have contributed to upward pressure on natural gas prices, demand alone does not seem to explain the overall level of natural gas prices. This is especially true because the growth in demand was concentrated in two months (January and March), while spot prices continued to rise in April and May," the report said.

"Importantly, there was not an exceptional surplus of gas supply in July 2008 when prices started to plunge. August does show a significant supply surplus due to the low summer demand from power generators; however, the market balance was only mildly different from the five-year average and previous two years," according to FERC.

On the storage front, inventories "remained at the five-year average through the end of May and then dropped to levels in early July that the market had not experienced since 2004. Because the relatively low storage levels during the price run-up occurred in the spring and early summer, when those injecting gas have the maximum flexibility in their storage choices, the steep price increase likely caused the low inventories," not the other way around, the report said.

"While 2008 storage was at or above the five-year average most of the year, 2008 prices were far above other periods of similarly moderate storage levels. Specifically higher summer storage deficits occurred in the summers of 2000 and 2003, without a similar impact on summer prices," FERC noted.

The report further said the natural gas pipeline infrastructure burgeoned in 2008. The Energy Information Administration estimated that new interstate and intrastate pipeline projects added an unprecedented 43.9 Bcf/d of capacity last year, almost three times the capacity additions from previous years.

"Some of the most significant pipeline capacity additions altered traditional flow patterns and transformed physical transportation price relationships...Increased gas flows from the Rockies Express Pipeline (REX) and new shale supplies put downward pressure on Midcontinent prices, which were, at times, the lowest cost markets in the United States in 2008. The separation of prices in northern and southern California grew by 30 cents, a 64% increase from 2007, as Permian gas displaced by REX depressed southern California prices," the report said.

The electricity market in 2008 was like a boat on the ocean, bobbing up and down in response to external forces such as fuel prices, according to the FERC report. "Electricity market outcomes -- including spot prices, the dispatch order of generating units, the value of FTRs [financial transmission rights] relative to realized day-ahead congestion costs and the construction of new electric generators -- were driven largely by market forces outside the electricity market." The one exception was the maturing alternative energy market, it said.

Electricity prices for major eastern trading hubs started 2008 in the range of $60/MWh to $80/MWh, rose to between $100/MWh and $160/MWh during the summer months, and ended the year in the range of $40/MWh to $70/MWh, the report said. There was a similar pattern in the western United States, with the exception of the Mid-Columbia price point, where late and robust hydro generation suppressed summer prices.

The dramatic swing in electric prices was driven by equally dramatic swings in fuel prices, principally natural gas, coal and oil, according to the markets report. Spot gas prices peaked at around $13/Mcf in July and ended the year below $6/Mcf. Central Appalachia coal futures prices rose significantly from around $55/ton to a high of almost $140/ton during the first seven months of the year and then fell back to $62/ton at the end of 2008, it said.

In addition to being buffeted by high fuel costs, "the financial crisis simultaneously raised the cost of capital to fund investment in new generation and reduced the access to capital. Thus, just as one source of pressure (physical construction costs) on long-term electricity prices was seemingly reduced, another source of pressure (financing costs) was growing," it noted.

"Companies may be delaying expenditures of any kind that are not pressing due to the increased cost of debt. In addition, investors...may defer investment in new power generation as they wait for costs to fall further," according to FERC.

The Power Capital Costs Index, which is produced by Cambridge Energy Research Associates, tracks the cost of materials, major equipment and construction labor needed to build new power plants. The index estimates costs nearly doubled in mid-2008 from 2003. "Much of this cost increase resulted from elevated costs of raw materials and scarcity in specialized equipment and labor for this type of construction." But in addition to those factors, two systemic changes in the economy have occurred since mid-2008 -- commodity prices fell substantially and the credit crisis led to reduced capital, the markets report said.

Because of the limited access to capital and the higher cost of capital, Edison Electric Institute reported earlier this year that capital expenditure budgets of electric utilities have been reduced by about 10% for 2009 and 2010. "[EMO] staff's survey of canceled and postponed generation projects indicates that the total capacity of canceled and postponed projects through [the first half of this year] is larger than the capacity of projects canceled and postponed in all of 2008." The rate of cancellations and postponements of gas-, coal- and oil-fired generation facilities was higher than those for hydroelectric and wind projects, according to the FERC report.

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