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Four reasons natural gas prices will stay depressed

Often called "the clean fossil fuel," natural gas creates significantly lower emissions than coal when burned to generate electrical power or when substituted for home heating oil in our furnaces.

However, rapid demand growth, depletion of existing resources and insufficient new production during the past decade resulted in record prices that put the economics of natural gas use squarely at odds with its environmental benefits.

When natural gas prices repeatedly exceeded $10 per 1,000 cubic feet in recent years, the cost of producing electricity from gas was more than double the cost of coal generation. The previously embattled coal industry was revived, and talk of clean-coal technologies quickly spread through industry and government circles.

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At the same time, renewable resources, such as wind and solar, made not only environmental but also economic sense.

When the credit crisis hit North America's economy, natural gas prices collapsed below $5 per 1,000 cubic feet in the fall of 2008, and have stubbornly remained there, despite resurgent prices of other energy commodities, like oil.

Although mild weather and weakened economic activity served to abate demand in the short term, four trends have emerged that could keep natural gas prices near current levels for several years to come, in contrast to many published forecasts.

While this would benefit gas consumers, it would have adverse consequences for Western gas producers and throw into question elements of the energy policies and environmental legislation currently being enacted.

First, there has been a structural shift in the supply of natural gas away from conventional production, where individual wells target discrete pockets of natural gas, to unconventional sources, where many wells are required to unlock previously unrecoverable gas from rock formations such as shale.

These previously untapped shale gas resources have proven to be more productive than expected. As a result, supply constraints could be alleviated, reducing the need for high-cost imports. On the other hand, we estimate that many new shale gas projects require prices above $6 per 1,000 cubic feet to be economically viable, making them unprofitable at today's prices.

Second, this robust North American gas production has been supplemented in recent months by higher imports of liquefied natural gas, or LNG, from Africa and the Middle East. LNG is natural gas produced in regions with limited demand, which has been cooled and compressed into a liquid that can be transported around the globe. It appears that 2009 could be a record year for new LNG production capacity, just as global gas demand is at a low point, possibly creating a temporary global oversupply that could put further downward pressure on North America's gas prices.

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The third major trend is U.S. energy policy. Paradoxically, the core elements of current "green energy" plans, including the addition of renewable energy sources (such as wind and solar) and energy conservation measures, could result in less electricity generated from lower-emitting gas plants and virtually unchanged generation from higher-emitting coal.

Gas generation is more expensive than coal in the absence of significant charges for carbon dioxide emissions and is therefore more susceptible to declining demand for electricity and competition from renewables.

Moreover, wind generation is expensive to install, often operates at below 30 per cent capacity, produces electricity at unpredictable times, and is supported by substantial consumer and government subsidies.

The result of the current energy and stimulus plans may therefore be a legacy of high-cost generation and little reduction in carbon dioxide from coal-fired generation.

Finally, the coal industry may prove to be more resilient to carbon dioxide regulation than previously thought. Gas-fired power plants will benefit from carbon dioxide regulation because they produce half the carbon dioxide of coal plants. However, coal producers, shippers and consumers may absorb substantial carbon dioxide costs through lower margins in order to defend their businesses, thereby limiting the shift from coal to gas generation and the accompanying growth in gas demand.

The cumulative effect of these trends is that North America could have excess available gas supply for a number of years, a significant shift from the prevailing views of recent years. Naturally, this will benefit consumers and gas-consuming industries through lower prices and better access to a cleaner fuel.

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On the other hand, this creates a challenging picture for Western Canadian gas producers and could put significant pressure on several high-profile gas developments, such as in the Mackenzie Delta.

It also suggests that legislators should revisit some of the fundamental assumptions driving current energy and environmental policy on both sides of the border.

Jiri Maly is a principal in the Toronto office of McKinsey & Co. Tommy Inglesby, a principal in the Houston office of McKinsey, also contributed to this article.

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