Posted by: bmeverett | August 17, 2012

What to do with all this gas?

Every once in a while we get a chance to formulate national policy on a clean sheet of paper without decades of baggage and hardened positions. The new and unexpected boom in natural gas production from shale deposits provides us with precisely such an opportunity.

The huge increase in natural gas production in the US has driven natural gas prices down dramatically. According to the Energy Information Administration (EIA), wellhead prices of natural gas (essentially the price at the production site before transmission to demand centers) peaked at $10.79 per thousand cubic feet (MCF) in July of 2008, when oil prices were also high. You estimate the equivalent price per barrel of crude oil by multiplying the natural gas price in $/MCF by 6. Hence, $10.79 per MCF is equivalent to about $66 per barrel of crude oil. By last month, wellhead natural gas prices had fallen to below $2 per MCF – about $12 per barrel of crude oil. This is an astonishing change.

The traditional markets for natural gas in the US – residential/commercial heating and power generation – are getting saturated. Just a few years ago, the EIA projected that most new electric generating capacity in the US would come from coal. In recent years, the forecast has shifted to natural gas, which is by now the cheapest energy source. In fact, natural gas is now so inexpensive that new natural gas power plants may actually be cheaper than many existing coal plants. Even so, the price of natural gas continues to fall. What will happen? The answer is some combination of four different developments.

First, the price of natural gas may just continue to drop until companies no longer find it profitable to produce more gas. This is already happening, and a number of oil companies are beginning to wonder whether their big investments in shale gas were wise. People can only use so much gas to heat their homes and businesses, and new power plants can only be built so fast.

Second, however, new markets for natural gas may develop. One revolutionary possibility is the penetration of natural gas into the transportation market. Natural gas already powers some city buses and fleet vehicles, but the application is quite small in our overall energy balance. Electric cars could increase the demand for electricity and hence indirectly for natural gas, but, as discussed several times in previous postings, battery technology is still not good enough to support the economic manufacture of electric cars with acceptable performance parameters, particularly range and recharge time.

Natural gas is a high octane fuel and works perfectly well in internal combustion engines. The economics of natural gas passenger vehicles continues to improve. Natural gas currently costs the equivalent of about 30¢ per gallon at the wellhead. The issue is the infrastructure required to move the gas to consumers. Although there are a few commercial natural gas refueling stations scattered around major urban areas, passenger cars require an extensive refueling network. There are, for example, over 100,000 gasoline service stations in the US, compared to about 500 natural gas stations. Gasoline is a liquid at ambient temperature and pressure and is easy and inexpensive to move around. You can buy gasoline in bulk at a refinery, for example, but you will save only about 25¢ per gallon compared to the price delivered to a service station. Moving gases around is much more expensive. Although natural gas costs around $2 per MCF at the point of production, commercial buyers (like refueling stations) pay about $8 – four times as much. The construction of sufficient infrastructure to support a large national fleet of natural gas vehicles would be very expensive and time-consuming. There are other issues around natural gas vehicles, such as reduced range, but these problems could probably be solved.

A third possibility is that we could allow natural gas to be exported. Global trade in natural gas is relatively small, since the costs of moving gas long distances are high. Large international pipelines cost about $5 million per mile to build, so a 1,000 mile pipeline would cost about $5 billion. Natural gas can also be liquefied by cooling it down to about minus 260° F and then shipping the gas in special cryogenic tankers – a very expensive process. Demand for natural gas on the world market increased dramatically after the Fukushima nuclear disaster in Japan in 2011. Japan has partially compensated for the near total shutdown of its nuclear capacity by buying as much liquefied natural gas (LNG) as it can. World market prices have recently been as high as $15 per MCF compared to $2 in the US.

Exporting natural gas from the US would require substantial investments in pipelines and export terminals, but the economics may support this option. A more important issue would be the politics of gas exports. Energy issues have never been well understood by our elected officials, who tend to focus more on public perceptions than economic reality. When the Alaska Oil Pipeline was built in the early 1970s, the industry faced a logistical issue. The relatively heavy Alaskan crude was not well-suited for West Coast oil refineries. Moving the oil around to the Gulf Coast, however, was expensive, since large oil tankers cannot transit the Panama Canal. One sensible idea floated in Washington was to allow the oil companies to export Alaska oil to Japan in exchange for other oil closer and more accessible to the Gulf Coast. This proposal was savaged in Washington by politicians claiming that Alaskan oil was “needed” in the US and should not be exported until it was “surplus.” Many elected officials argued, “We didn’t spend all this money and confront all the environmental issues surrounding the pipeline just to have the Japanese enjoy the benefit of our oil.” I call this argument the “molecular theory” of energy.

Any Economics 101 course will teach you that value is an economic, not a physical quality. The value of a car manufactured in Detroit does not depend on whether the car is bought by an American or a Canadian. Nor does it make any sense to talk about restricting car exports until cars are no longer “needed” in the US. Products exported from the US are sold for cash, not given away free to foreigners. If the highest-value outlet for US gas is in international trade, so be it. This simple argument from trade theory is clear, compelling and supported by every economist in the country. Unfortunately, it’s also a hard sell to politicians, who are much more interested in opinion polls than in economic growth.

There is one final option for US natural gas – conversion into oil. The liquefied natural gas process does not change the physical composition of the gas. Natural gas is mostly methane. LNG is still methane, but in liquid form for easy transport. When it’s delivered and burned, it’s still methane. There is another process, however, called Fischer-Tropsch, which actually changes the molecular structure of methane into heavier liquid compounds, which can be used directly as motor fuels and other petroleum-type products.

A methane molecule consists of one carbon atom surrounded by four hydrogen atoms (CH4). When methane is burned in air under normal conditions, it produces carbon dioxide (CO2) and water (H2O). When burned with limited oxygen under controlled conditions, however, methane produces carbon monoxide (CO) and hydrogen (H2), a mixture known as “synthesis gas”. With special catalysts under controlled temperature and pressure, synthesis gas can be converted into paraffinic waxes. These waxes can then be upgraded to excellent petroleum products. This synthetic oil is free of any contaminants and, in fact, looks like water. The octane rating is generally too low to make good gasoline, but it’s a great diesel fuel or lubricant feedstock. The only byproduct of the process is water.

The chemistry of this process has been known for a very long time. The Nazis used it to make synthetic oil from coal, as did the South Africans when apartheid sanctions isolated them from the world oil market. The problem is economic rather than technical. Building a gas-to-liquids (GTL) plant is rather like building a refinery. Shell’s Pearl GTL plant in Qatar is expected to produce 140,000 barrels per day of synthetic oil from natural gas at a capital cost of $18-19 billion. Not small change. Furthermore, about 30% of the energy content of the natural gas is lost during conversion. Nonetheless, this technology may grow in significance if natural gas remains significantly cheaper than oil, as it is today.

Now, back to the policy question. We have, as noted above, a unique opportunity to do the right thing. There will be a strong temptation by many to look to government to plan the development of the new natural gas industry. Politicians of both parties will jump at the chance to manage the natural gas market. That would be exactly the wrong thing to do, replacing economically rational market decisions with purely political ones. If you liked the Keystone Pipeline decision, you’ll love this one. Instead, the federal and state governments should express their willingness to provide the required permits and eminent domain support for whatever solutions the market dictates. Don’t subsidize, and don’t prohibit. Don’t demagogue, and don’t study the options to death. Let the market decide and facilitate what the market wants to do. Easy? Sure. Likely? No.


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