Shale gas glut, but won’t last? The underlying model

Lynne Kiesling

Ken Silverstein has a good article in Forbes on the business prospects for shale gas developers (and I’m glad to see him there, having followed his work for a very long time). Since he asks in the title whether low shale gas prices are a mirage, I think it’s useful to go through the underlying economic analysis that’s embedded in his article. Note: if you are a principles student, this is a good exercise for you, because there will be a lot of shifting of supply and demand curves.

We start with the current boom in shale gas production, the consequence of technological change — horizontal drilling makes gas deposits available that were not with conventional technology. How do we model technological change? As an outward shift/increase in the supply of natural gas; at every price the quantity supplied is now greater, at every quantity the supplier’s marginal cost has fallen. For a given demand in the natural gas market, moving along the demand curve toward the new equilibrium means that price falls and quantity of gas sold and consumed rises. That’s a good model of where we are now.

But this equilibrium is unlikely to persist. Why? Because people don’t consume natural gas in isolation; we make decisions at the margin about when to substitute natural gas consumption for other fuel consumption, depending on the relative prices of those fuels. Even assuming all other things equal (a strong assumption), the falling price of natural gas will make the relative price of coal (Pcoal/Pnatgas) go up. Natural gas has become cheaper relative to coal, and at the margin consumers will substitute out of coal and into natural gas, even barring any other changes. We model this effect as a decrease in demand for coal, a leftward shift in the demand curve. For a given supply of coal, that means a lower price of coal (bringing their relative prices back into some balance that I won’t bore you with here) and lower quantities of coal consumed. In the short run that happens by substitution where it’s easiest, in industries using technologies (engines, turbines, smelters, etc.) where it’s relatively easier to switch between fuels.

Note also that regulatory changes, such as environmental regulations to reduce greenhouse gas emissions, will exacerbate the substitution out of coal, and shift the demand for coal even further to the left.

Another important factor in a dynamic economy is time, and the fact that over time, by adapting to these changes, people create new changes. One such change that Ken focuses on in his article is the extent to which electricity generators will, over time, retire coal generators and replace them with natural gas turbines. The longer-run effect of a low natural gas price (and low natural gas price relative to coal, so it’s in both absolute and relative terms) is the replacement of more durable, longer-lived technologies that use coal. Note the win-win here: not only is it cheaper (all other thing equal) to generate electricity with gas because of the shale gas, it’s also a cheaper way to meet environmental regulations because of the lower carbon footprint of natural gas. How do we model this effect? As an increase in the demand for natural gas, a rightward shift in the demand curve. So now in the natural gas market we have had an increase in supply and an increase in demand (yes, you should be jotting down graphs here!).

What do we learn about increases in supply and demand in the same market? The quantity transacted goes up, unambiguously. But price can go up or down relative to the initial price. That’s what we’ll see play out over the next several years, as electricity generators build more natural gas capacity and retire coal capacity. The empirical question will be whether or not the size of the increase in their demand outweighs the size of the increase in supply. That interaction will determine whether or not the current low prices are a mirage, although I admit that I object to that language in describing them; they aren’t a mirage, because they are real. But they are probably temporary. However, even if prices go up because of generator demand for natural gas for electricity, consumers benefit through controlling the economic and environmental costs of electricity generation. It’s just that their benefit will show up there instead of in the reduction in their home heating/stove bills. But don’t let the “mirage” framing of this point trick you into thinking that generator demand for natural gas is bad for consumers.

Soul searching in economics, Davos division

Lynne Kiesling

In Davos on Friday, the FT’s Martin Wolf chaired a panel discussion of economists including Peter Diamond, Joe Stiglitz, Robert Shiller, and Brian Arthur. His summary of the discussion is very well worth reading, because he highlights 10 important ideas that arose in the conversation. I’m going to summarize them here, which is no substitute for reading his description:

  1. First, orthodox economics had, in the years leading up to the crisis, become more a cult than a science, particularly with the assumption that what exists in competitive markets has to be the best possible outcome, since, if it were not, it could not exist.
  2. Second, let a thousand flowers of thought bloom.
  3. Third, the sociology of the profession – the need to define and defend a core discipline that can be taught to students and so determines what it means to be an economist – militates against such heterodoxy.
  4. Fourth, human beings are not rational calculating machines.
  5. Fifth, time matters in economic processes, which are, in general, not reversible and not characterised by any sort of equilibrium.
  6. Sixth, the world is not computable.
  7. Seventh, being a study of complex human behaviour, in which the world is created by human understand [sic] and motivations, economics is hard.
  8. Eighth, in theory it is right and proper to abstract in order to focus on a specific phenomenon. In addressing policy, this is irresponsible.
  9. Ninth, even though economists get much wrong, they still have much to offer to non-economists who tend to assume that economic problems are far more simple than they actually are.
  10. Tenth, there is a great danger that in rejected the most simplistic pro-market mantras, economists and policymakers will embrace even more dangerous and naïve statism.

This list is full of insights and healthy ideas to rediscover in economics, such as multi-disciplinary discourse and research, a dose of humility in applying theory that uses simplifying assumptions to real-world policy situations, and a meaningful recognition of the complexity of humans and the social systems we create and that emerge from our interactions. I say “rediscover” because several of the points above had been part of economics (even including Keynes, who cautioned people on #6) over the past two and a half centuries, but have been lost as our field has evolved toward more formalism, to the exclusion of other methods of analysis.

I think this soul searching is healthy, and that it’s valuable to have such an accomplished set of economists from a variety of sub-field backgrounds discussing them. How many economists, especially theorists at top research universities who “whisper in the ears of emperors”, will agree with these points, internalize them, and use these ideas to evolve their research in directions more consistent with them?

Keystone XL jobs: estimates range from a few thousand to about 1.47 bazillion

Michael Giberson

The Columbia Journalism Review takes a look at the jobs numbers that have been cited in news stories about the Keystone XL pipeline and traces them back to their shaky foundations.

It is a detailed and useful reminder of the slim link to reality that these claims have. (I use an easier method: anytime I hear a politician or project promoter talk about jobs, I assume they are lying.)

But more to the point, such job counting exercises ought to have no influence in public policy decisions, so no role in policy discussions. Policies ought to be evaluated on whether the overall expected benefits are reasonably believed to exceed the overall costs, with a moment or two of silence for the peoples whose rights will be trampled by the projects.

If jobs are the goal, we can mandate that every truck used have five drivers and every pipe laid be dug up twice and buried again. I trust that even the newspaper reporters of the world can see how silly that would be. (The politicians? I don’t have much hope, but it doesn’t really matter since I already assume they are lying.)

Minnesota biomass projects squeezed by low natural gas prices, leaves some hoping for higher gas prices

Michael Giberson

The Minneapolis Star Tribune reports that low natural gas prices are putting the squeeze on biomass-based energy projects in Minnesota, in some cases including biomass projects supported by direct taxpayer or ratepayer subsidies. One example, an ethanol plant once gained about 20 percent of its heat from a $20 million biomass gasification system. The system has been idle for a year while the plant relies on cheaper natural gas.

The article notes that the biomass investment was initiated in 2008, a year when gas prices topped $13/mmbtu and before it was clear what the shale gas boost was going to do to gas prices. (Current gas prices are below $3/mmbtu.)

More:

The operators of two recent biomass projects — at the University of Minnesota Morris and Rahr Malting Co. in Shakopee — say they probably would be saving money if they had stayed with natural gas. Neither had decided to abandon biomass, however.

“We are stuck in a situation where I start wishing for the price of natural gas to go up, which is not good for everyone else,” said Stacy Cook, vice president of operations for Koda Energy, a $60 million privately financed joint venture of Rahr and the Shakopee Mdewakanton Dakota Community.

Cook said the Rahr family and the Dakota community are committed to the combined heat and power plant that burns agricultural byproducts, wood or energy crops. It supplies electricity to Xcel and process heat to the malt plant.

“They are looking at a 30-year picture,” Cook said of the plant’s owners. “If you start looking too short-term, it gets too depressing.”

The article then tries to offer a bit of hope to the biomass investor in the way of citing, without almost no context, the highest price projection out of the Energy Information Administration’s study of the effects of natural gas exports on price.  (Namely, the 54 percent price increase by 2018. As discussed here before, the 54 percent outcome is just one of many export and production scenarios that EIA tested with their economic models. It isn’t the most likely scenario by any stretch of the imagination.)

Here is how the Star Tribune cast the possibility: “Natural gas prices may not stay low. Last week, the U.S. Energy Department projected that gas prices could rise 54 percent by 2018 if liquefied natural gas becomes a major export commodity.”

The owner of biomass-producing or consuming assets can wish, but I wouldn’t put my money on it.

A Friday flash

Lynne Kiesling

I found a lot of interesting and insightful thoughts in my morning reading today; here’s a synopsis:

  • Election year linguistics 1: The New York Times has an analysis of the language used by Obama and the four presidential candidates; at Cato at Liberty, David Boaz points out how different Ron Paul’s emphasis is from all of the others. He speaks about the fundamentals of both economics and the American small-l-liberal political tradition, while the others focus on topics that are more matters of expediency.
  • Election year linguistics 2: Newt Gingrich is currently getting his panties in a twist about people calling his ideas and his rhetoric “grandiose”, claiming that grandiosity is a defining American characteristic. I encourage Mr. Gingrich to consult his dictionary. According to dictionary.com, the first two definitions of “grandiose” are (1) affectedly grand or important; pompous and (2) more complicated or elaborate than necessary; overblown. I submit that while these meanings fit Mr. Gingrich, they are not defining characteristics of American culture, historically or at present.
  • Speaking of rhetoric and meaning, the Wall Street Journal has an interview, The New Theories of Moral Sentiments, with Deirdre McCloskey. She is doing more than any one person I know to return the perspectives of political economy and economics as transcending “Max U” to the professional and policy conversations.
  • Adam Thierer has a review of Liars and Outliers, the new book from security expert Bruce Schneier. Schneier analyzes the social institutions and mechanisms that enable trust to evolve in societies, and it sounds like it will be a great read; I’ve been looking forward to it, and Adam’s review whets my appetite even further. Schneier is the preeminent voice of reason in the debate over the surveillance state, so this book is self-recommending.
  • Also in technology, Steven Titch unpacks Google’s consolidation of its privacy policies across its suite of applications, and discusses what information Google does and does not capture, and what they will and won’t do with it. Very useful corrective to some of the anti-Google hyperbole, although I have some remaining skepticism.

Happy Friday!

Was federal government support critical to the shale gas breakthrough?

Michael Giberson

In the State of the Union address, President Obama invoked a little federal government research history and then jumped to the kind of logical non sequitur so common to those who see the world through politically-colored glasses:

The development of natural gas will create jobs and power trucks and factories that are cleaner and cheaper, proving that we don’t have to choose between our environment and our economy. And by the way, it was public research dollars, over the course of thirty years, that helped develop the technologies to extract all this natural gas out of shale rock – reminding us that Government support is critical in helping businesses get new energy ideas off the ground.

Reminds me of the old saying, “Success has many fathers.” It is true that the federal government supported research into technologies used to extract gas from shale, but it is a politician’s self-serving leap to then suggest it means “Government support is critical in helping businesses get new energy ideas off the ground.”

The President’s comment echoes a claim advanced by the Breakthrough Institute last month (as they were happy to point out after the speech), namely that credit for the shale gas boom ought to go to the federal government. I commented on the Breakthrough Institute’s claim in December (see here and here), and the Master Resource blog has republished the first of those posts this morning.

If the federal government were responsible for the shale gas boom, wouldn’t we have expected to see shale gas resources on federal government land developed before privately-owned resources were explored? Instead what we have is the President, in the same State of the Union speech, announcing disclosure requirements for companies that want to use hydraulic fracturing on federal lands – meaning, given the way policy gets developed, that sometime soon a regulatory proposal on the issue will be initiated and in several months, or maybe a year or two, a rule will be in place.

There is nothing wrong with the checks and balances in the policy making process, even though they cause the federal government to sometimes move at a glacial pace. But anyone with the least familiarity with running a business will know that this isn’t the way breakthroughs get made in the private sector.

I certainly would recommend the interested reader check out the Breakthrough Institute’s work on the issue. In addition to the Washington Post op-ed linked above, on their blog they have a summary of their message, interviews with former Mitchell Energy geologist Dan Steward and Penn State University geologist and fracking expert Terry Englander, and other supporting information. The basic reporting presented is quite good. Just be ready to form your own conclusions.

 

 

The SOTU energy policy extract

Michael Giberson

For your convenience, the energy policy parts from last night’s State of the Union address. Be aware that I’ve dropped some non-energy words, phrases or even short sentences without indicating where such edits happened in order to make this extract relatively clean. In some cases I kept non-energy bits that seemed useful as context for the energy discussion.

Think about the America within our reach: A future where we’re in control of our own energy, and our security and prosperity aren’t so tied to unstable parts of the world.

I want to speak about how we move forward, and lay out a blueprint for an economy that’s built to last – an economy built on American manufacturing, American energy, skills for American workers, and a renewal of American values.

Innovation demands basic research. Don’t let other countries win the race for the future. Support the same kind of research and innovation that led to the computer chip and the Internet; to new American jobs and new American industries.

Nowhere is the promise of innovation greater than in American-made energy. Over the last three years, we’ve opened millions of new acres for oil and gas exploration, and tonight, I’m directing my Administration to open more than 75 percent of our potential offshore oil and gas resources. Right now, American oil production is the highest that it’s been in eight years. That’s right – eight years. Not only that – last year, we relied less on foreign oil than in any of the past sixteen years.

But with only 2 percent of the world’s oil reserves, oil isn’t enough. This country needs an all-out, all-of-the-above strategy that develops every available source of American energy – a strategy that’s cleaner, cheaper, and full of new jobs.

We have a supply of natural gas that can last America nearly one hundred years, and my Administration will take every possible action to safely develop this energy. Experts believe this will support more than 600,000 jobs by the end of the decade. And I’m requiring all companies that drill for gas on public lands to disclose the chemicals they use. America will develop this resource without putting the health and safety of our citizens at risk.

The development of natural gas will create jobs and power trucks and factories that are cleaner and cheaper, proving that we don’t have to choose between our environment and our economy. And by the way, it was public research dollars, over the course of thirty years, that helped develop the technologies to extract all this natural gas out of shale rock – reminding us that Government support is critical in helping businesses get new energy ideas off the ground.

What’s true for natural gas is true for clean energy. In three years, our partnership with the private sector has already positioned America to be the world’s leading manufacturer of high-tech batteries. Because of federal investments, renewable energy use has nearly doubled. And thousands of Americans have jobs because of it.

When Bryan Ritterby was laid off from his job making furniture, he said he worried that at 55, no one would give him a second chance. But he found work at Energetx, a wind turbine manufacturer in Michigan. Before the recession, the factory only made luxury yachts.

Our experience with shale gas shows us that the payoffs on these public investments don’t always come right away. Some technologies don’t pan out; some companies fail. But I will not walk away from the promise of clean energy. I will not cede the wind or solar or battery industry to China or Germany because we refuse to make the same commitment here. We have subsidized oil companies for a century. That’s long enough. It’s time to end the taxpayer giveaways to an industry that’s rarely been more profitable, and double-down on a clean energy industry that’s never been more promising. Pass clean energy tax credits and create these jobs.

We can also spur energy innovation with new incentives. The differences in this chamber may be too deep right now to pass a comprehensive plan to fight climate change. But there’s no reason why Congress shouldn’t at least set a clean energy standard that creates a market for innovation. So far, you haven’t acted. Well tonight, I will. I’m directing my Administration to allow the development of clean energy on enough public land to power three million homes. And I’m proud to announce that the Department of Defense, the world’s largest consumer of energy, will make one of the largest commitments to clean energy in history – with the Navy purchasing enough capacity to power a quarter of a million homes a year.

Of course, the easiest way to save money is to waste less energy. So here’s another proposal: Help manufacturers eliminate energy waste in their factories and give businesses incentives to upgrade their buildings. Their energy bills will be $100 billion lower over the next decade, and America will have less pollution, more manufacturing, and more jobs for construction workers who need them. Send me a bill that creates these jobs.

Building this new energy future should be just one part of a broader agenda to repair America’s infrastructure. So much of America needs to be rebuilt. We’ve got a power grid that wastes too much energy.

I recognize that people watching tonight have differing views about energy. But no matter what party they belong to, I bet most Americans are thinking the same thing right now: Nothing will get done this year, or next year, or maybe even the year after that, because Washington is broken.

I’m a Democrat. But I believe what Republican Abraham Lincoln believed: That Government should do for people only what they cannot do better by themselves, and no more.

On the other hand, even my Republican friends who complain the most about Government spending have supported clean energy projects for the folks back home.

The last four paragraphs fell outside the main energy portion of the speech, but since energy was mentioned I’ve included them here.

The full speech clocked in just under 7000 words, while this extract is a bit over 900 words. The word energy appeared 23 times in the speech.

The Hill‘s E2 Wire blogged the energy content of the speech. See:

For another view, here is a report from CNN.

Can anyone name a major energy policy initiative that emerged from any prior State of the Union address? That is to say, any reason to expect any of this to matter beyond a week from now?

My natural inclination is to say these things don’t matter, but the 2006 State of the Union address lauded the promise of cellulosic ethanol and the following year the Renewable Fuels Standard was implemented.