"The elasticity of demand is great for high prices, and great, or at least considerable, for medium prices; but it declines as the price falls; and gradually fades away if the fall goes so far that satiety level is reached."
-Alfred Marshall, "Principles of Economics"
by Tanya Bodell
Natural gas prices have reached new lows, settling in at levels seen during the 1990s. The question on everyone's mind seems to be: How low can it go? The answer depends in large part on the power sector.
Price Elasticity of Supply
Price elasticity of supply reflects the percentage change in quantity produced given a percentage change in price. Elastic supply curves experience steep declines in production with small price changes; inelastic supply requires substantial price movements before production levels change. Excess supply resulting from the increased availability of shale gas in the marketplace has been blamed for falling gas prices. Yet as prices continue to decline, the production overhang continues. Why? Natural gas producers might be hindered from responding immediately to price signals for various reasons. Barriers to exit include contractual obligations and expiring land lease rights. For many acres in the potential natural gas production in shale regions, natural gas companies have many "drill-'em-or-lose-'em" leases. Even if natural gas prices drop below the marginal cost to extract, combination plays that are drilling for liquids barrel will continue to produce natural gas as a low-production cost by-product. The value of production of a natural gas well with liquids is more than twice the value in dollars per 1,000 cubic feet. Announcements by shale gas producers that they are pulling back production are followed by press releases from oil companies announcing they intend to accelerate drilling. The overhang in natural gas supply can be expected to continue despite low gas prices.
Price Elasticity of Demand
The price elasticity of demand is the ratio of the percentage change in quantity demanded given a percentage change in price. The more elastic demand is, the greater the response to a change in price. Inelastic demand is represented by a vertical line in supply-demand charts, indicating that no matter what the price, demand remains the same. Elasticity also has a temporal aspect, given the time lag between the price signal and the ability to respond to that signal. Long-term demand becomes increasingly more elastic as time allows for greater adjustment to prices.
Approximately one-third of natural gas consumed in the United States is used to produce power. Another third is used by the industrial sector; residential and commercial demand composes most of the balance. Although end-use demand for natural gas is very responsive to weather conditions, short-term price elasticity of demand is relatively muted. For example, short-run elasticity of residential demand for natural gas is very inelastic (between -0.1 and -0.2). Price elasticity of demand equal to -0.1 means a 10 percent decrease in price results in only a 1 percent increase in demand. Although commercial and industrial demand is slightly more elastic in the short run, long-run ability to adapt to price changes requires two to five years. A major shift in demand to exports requires around seven years to allow liquefied natural gas export terminals to be converted, built or both. Longer-term flexibility increases price elasticity of demand.
The Role of the Power Sector
The potential for large swings in demand for natural gas from the power sector is greater than in the past.
First, the U.S. power sector has excess generation capacity, including underutilized natural gas-fired power plants. Second, increased coal prices have placed the marginal cost of coal plants on parity with natural gas-fired production creating a more competitive environment between natural gas and coal-fired generation. Third, high oil prices continue to encourage drilling, contributing to excess supply of natural gas, allowing for larger price drops.
With natural gas storage levels at historic highs, projected overhangs need to find immediate demand potential to absorb excess gas supply. The electricity sector offers a significant source of swing demand for natural gas. As a result, natural gas prices will fall to levels required to allow natural gas-fired generation to displace a sufficient amount of coal-fired generation and absorb excess natural gas supply. Expect combined cycles and even gas-fired peaking plants to experience increasing capacity factors as natural gas supply finds a home.
How low can gas prices go? The standard economic answer: low enough for demand to equal supply.
Tanya Bodell has provided business advisory and expert support to clients in the electric power sector for more than 17 years. She advises clients on investment strategy, asset valuation, mergers and acquisitions, regulatory outreach and market analysis.