While most assets tied to US economic recovery have soared in recent weeks on increased optimism fuelled by better incoming data, US natural gas remains firmly in the doldrums at sub $4, down from nearly $14 last Summer. Yet it has the potential to soar over the next 12-18 mths on even a muted rebound in industrial activity given the collapse in drilling rig numbers to under 800, a level not seen since 2003, as shown in the chart below. Oil supplies 40% of total US energy consumption, with coal and gas supplying 25% each (although coal supplies 50% of electricity generation). By 2020, more than 33% of the country’s electricity could be generated through burning natural gas. The reasons are simple: natural gas power plants are far cheaper and faster to build than nuclear power plants or indeed 'clean' coal fired generators, are the lowest carbon fossil fuel source, and don't require the huge electrical grid upgrade needed to expand solar/wind capacity significantly. They provide the fastest, most cost-effective way to reduce the carbon footprint of US energy usage, while enhancing energy security.

Through deregulation of the natural gas market in the late 1980s and the creation of a North American free trade region, supplies of natural gas more than kept pace with demand in the 1990s. The result was a decade of gas priced at $1.61 to $2.32 per million British thermal units (Btu). But, as ready supplies of natural gas peaked, demand continued to increase, and as cold weather pushed demand even higher, gas prices rose to nearly $10 per million Btu over the 2000-2001 winter. The new average price this decade has ranged from approximately $4 to $6 per million Btu in recent years, with a high of $14.25 per million Btu in the fall of 2005, following Hurricanes Katrina and Rita, and similar levels last Summer at the height of the commodity bubble.

Despite the advent of gas shale production which has reversed a declining trend in US production since 2006, natural gas in North America is getting harder to find; discoveries are coming in smaller quantities that flow at slower rates than in the past with rising marginal production costs above current spot levels. Oil fields over their lifetime generally exhibit gradually rising and falling production which looks like a bell curve on a graph. However, gas fields quickly reach a plateau in production (usually determined by what a pipeline can carry), remain on the plateau for a time, and then fall off very quickly once the decline starts . A more pressing issue is North America's limited natural gas storage capacity, which could result in a heating crisis in a severe winter.

Therefore, despite ample current stocks, it is conceivable that a hot summer (driving air conditioning use) followed by an unusually cold winter could bring storage down from record to uncomfortably low levels as near-term production is now inevitably set to decline. (Another upside risk is a major hurricane in the Gulf of Mexico that does extensive damage to the natural gas infrastructure there.) The U.S. EIA excepts natural gas consumption to fall 1.3% this year and rise 0.4% next year. The key factor in the production surge since mid decade has been unconventional gas shale plays, notably in Texas, Louisiana, Pennsylvania and British Columbia which have reduced fears of medium-term North American supply shortages, but may also make the Arctic pipeline projects redundant.

Unconventional gas meant U.S. production climbed to 56.7 billion cubic feet a day by last July from 48.9 in February 2007, a 14 percent gain in 17 months. Before 2006, production was in decline. Cambridge Energy Research (CERA) predicts overall output in the lower 48 U.S. states will climb to 60.6 bcfd by 2018 while Canadian production could jump to 19.6 bcfd by that year from 15.8 bcfd in 2009. To keep production of gas from shale formations growing, companies drill at a brisk pace and use expensive, specialized techniques to fracture the rock deep underground. While the costs of developing shale plays are dropping as producers gain experience with the technology and coax more output from each well,breakeven remains above $5 plus on most projects. The shale boom plus imports of LNG look set to undermine the economic rationale of hugely expensive Alaskan/Canadian pipelines, which on a 15% IRR basis would need a sustained gas price well north of $6.

With the expanding use of natural gas for residential use and as the primary feedstock in the manufacturing process for a wide variety of industrial processes, demand is expected to rise sharply over the next decade, particularly if as I expect 'clean' coal (ie carbon scrubbed) is a non starter at a cost of $1bn per power plant, and gas therefore grows its share of the electricity market.  Demand not only requires a ready supply of natural gas, but also a capacity to deliver that supply to consumers. And the two modes for delivering natural gas are by pipeline and ships designed to hold and transport vast amounts of LNG. State and local governments have made it increasingly difficult to build new pipeline networks, and have also complicated the transportation of LNG. There is plenty of natural gas outside of North America that can be transported to the United States at competitive prices if transport vessels have dedicated terminals unload the LNG (where it can be re-gasified for transport along an existing pipeline network). However, today, the United States has only five such sites, four of them built in the 1970s. There are plans to build more, but environmental and post-9/11 safety concerns have created major resistance from local communities.

Overall, we have a situation where supply has grown sharply in recent years with the exploitation of unconventional deposits, but the marginal cost of gas from shale is well above the current spot price. The current inventory overhang will gradually be eroded as a cyclical economic recovery takes hold in 2010, while LNG imports will be tightly constrained until further infrastructure is built and new Canadian/Alaskan supplies are probably a decade away but the impact of falling rig numbers will hit production later this year. If we get any hint that natural gas will have a starring role in the Obama 'green energy' agenda (and given its cost effectiveness, proven technology and speed of plant construction, it has huge advantages over nuclear and solar/wind), this would turbocharge a natural cyclical recovery over the next 18-24 months to at least the $6-7 area.