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Natural Gas 101

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What is it and where does it come from?
What Is LNG? How is it produced, shipped and delivered?
Natural Gas Pricing
Supply and Demand
What is storage and how does the market use it?
AECO vs. Henry Hub
Upward and Downward Pricing Pressures

What is it and where does it come from?

Natural gas is one of the cleanest, safest, and most useful forms of energy in our day-to-day lives.  It is the cleanest of the fossil fuels and originates from the remains of plants and animals that lived many years ago.  These organisms were buried and exposed to heat as a result of being highly compressed underneath thousands of meters of soil and rock. High temperatures and pressure transformed the once-living organisms in these rock layers into hydrocarbons.  Natural gas can also be generated biogenically, through the breakdown and degradation of organic matter by micro-organisms.

Natural gas is found in reservoirs beneath the surface of the earth. Large layers of impermeable rock trap the natural gas as it tries to migrate to the surface. Although the areas where the gas is trapped are referred to as pools, the natural gas molecules are actually held in small holes and cracks in various rock formations.  Subsurface reservoirs are accessed through drilling wells, vertically or horizontally as well as at depth.

Natural gas can be found by itself or in association with oil. As pure methane, it is both colourless and ordourless. The fact that natural gas is combustible and burns more cleanly than some other energy sources helps reinforce its position in the future energy supply chain.

Natural gas can be measured in a variety of ways, although the most common unit of measurement is the gigajoule (GJ), which signifies one billion joules, the metric measure of heat or energy. Other measures are; thousand cubic feet (Mcf) and British thermal unit (Btu).

Natural Gas Equivalents

1 cf 1 MBtu
1 Mcf 1 MMBtu
1 Mcf 1.054615 GJs
1 MMBtu 1.054615 GJs
6 Mcf 1 Bbl


Bbl Barrel
Bcf Billion cubic feet
BOE Barrel of oil equivalent
BOE/d Barrels of oil equivalent per day
Btu British thermal unit
Mboe Thousand barrels of oil equivalent
Mcf Thousand cubic feet
MMcf Million cubic feet
MMcfe Million cubic feet equivalent

Alberta is home to AECO, one of the largest natural gas hubs in North America. Through Alberta’s network of pipelines, gas is gathered from inside and outside Alberta and is then transported through numerous export transmission lines to many high-demand markets. The TransCanada mainline is Canada’s main inter-provincial pipeline that extends from eastern Alberta to Montreal. Major exporting systems connect Alberta with markets across the United States of America from California to New England. Alberta also has a large amount of storage capacity, which aids in the functioning of the hub.

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What Is LNG? How is it produced, shipped and delivered?

Liquefied Natural Gas (LNG) is natural gas that has been cooled to minus 260 degrees Fahrenheit, the point at which gas condenses to a liquid. In its liquid state, LNG is a clear liquid with a density about half that of water. This volume reduction permits cost-effective transportation of LNG over long distances. LNG is odourless, colourless, non-corrosive and non-toxic. Therefore, LNG will not pollute land or water resources.

LNG represents an important part of future energy supply within the Untied States. With an abundance of gas reserves worldwide, LNG is one of the fastest-growing segments in the energy industry, with an expected 10 to 15 percent annual growth rate over the next decade. Primary suppliers of LNG are Algeria, Nigeria, Egypt, Qatar, Trinidad, Malaysia, Russia, and Australia.

LNG has been safely transported across the oceans for more than 60 million miles during the past 40 years. These double-hulled tankers are specially designed and built to carry LNG. On land, LNG is stored at atmospheric pressure in specially engineered and constructed double-walled storage tanks. Most of these tanks have three-foot concrete exterior walls and an inner tank that is constructed from a steel-nickel metal alloy specifically designed to accommodate the cold LNG. Should a leak develop in the inner wall, all of the LNG would be contained in the space between the inner and outer walls. Sophisticated monitoring systems provide constant surveillance for any internal leaks.

LNG is converted back into natural gas by pumping the fluid from the storage tank and heating it to regasify the liquid. The gas is then ready for delivery through natural gas pipelines to homes and businesses.

LNG Supply Chain (1)

LNG Supply Chain
(1) Centre for Energy website

Over the past several years, the markets have witnessed a recurring phenomenon whereby there have been long periods with little to no new production introduced into the market, such as 2008 when demand overtook supply and pushed spot prices to record high levels. In 2007, the average spot LNG price in Asia was at the $9/MMbtu level shortly after a significant influx of new LNG production in the second half of 2006. As European and Asian markets quickly became saturated, the U.S. was hit by a wave of LNG, resulting in a record import year.

LNG will impact the overall pricing module to reflect global factors impacting the supply/demand fundamentals which will impact the net-back price for Alberta producers.

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Natural Gas Pricing

North American prices for natural gas are driven by the interaction of natural gas supply available from North American natural gas and oil fields, and demand. They are determined competitively on spot and futures markets reflecting current and expected supply and
demand conditions.

Over the course of a year, natural gas prices rise and fall for a variety of reasons. Consumer and industry demand for natural gas, and the supply available to meet their needs, are the fundamentals to understanding short-term natural gas prices. When the demand is higher, the price tends to rise and when there is more supply than what is needed, the price lowers.

The key factors affecting natural gas prices are:

  • Availability of North American supply relative to demand
  • Global supply/demand balance for LNG 

Natural gas prices are also affected by the strength of the economy and the availability of pipelines to move enough gas to meet consumers’ changing needs.

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Supply and Demand

The production of natural gas in Canada is based on competitive market forces: inadequate supply at any one time leads to price increases, which signal to production companies the need to increase the supply of natural gas to the market.  When supply is robust relative to demand, prices will decrease, which makes drilling and production less economic. Investment by exploration and production companies slows and supply declines.

In a perfect world, price signals would be strictly driven by supply/demand fundamentals and would be recognized and acted upon immediately. There would be little lag time between increased demand for natural gas, and an increase in supplies reaching the market. However, in reality, this lag time does exist. There are several barriers to immediate supply increases which affect the short-term availability of natural gas supply:

  • Availability of skilled workers
  • Availability of equipment
  • Permitting and well development
  • Weather and delivery disruptions
  • Technical understanding and risk associated with exploration and exploitation
  • Land access
  • Pipeline infrastructure
  • Regulatory compliance
  • The financial environment and access to capital
  • Fiscal competitiveness
  • Liquefied natural gas projects

Natural gas is used extensively in residential, commercial, industrial and power generation applications. Natural gas is primarily used by residential and commercial users as a source of space heating, water heating, clothes drying, and in cooking applications. The industrial sector uses natural gas as a source of process heat, as a fuel for the generation of steam and as a feedstock in the production of petrochemicals and fertilizers. The electric power generation sector uses natural gas to produce clean electricity.

Natural gas is also used by the oil and gas industry itself. For example, producers use natural gas as a fuel in processing facilities, while pipeline companies use natural gas to fuel the compressors which push the natural gas along the pipeline. Oil producers use natural gas in processing facilities, particularly in heavy oil secondary recovery schemes and in situ bitumen production and oil sands mining operations.

Many industries can switch to natural gas when the price of oil goes up, thus raising the price for natural gas. Recently, higher crude oil prices are leading large consumers to switch fuel sources – from crude to natural gas – increasing demand and tightening supply.

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What is storage and how does the market use it?

Natural gas storage can be held in inventory underground, under pressure, in three types of storage reservoirs: 1) depleted reservoirs, 2) aquifers, and 3) salt cavern formations.

Most of the 400 active underground storage facilities in the U.S. are in depleted natural gas or oil fields due to their abundance, lower capital conversion costs, and tendency to be located close to market regions.

In its simplest form, holders of storage work to cycle capacity and inject and withdraw, by putting in lower-priced gas and forward-selling a term in the future to capture a positive price spread.

Owners/operators of storage facilities may not be the owners of gas held in the ground, as most gas in storage is held under longer-term storage obligations to shippers, willing to take the spread risk, local distribution companies who use their gas to meet regional demand requirements, and producers looking to take advantage option of the value of the asset.

Gas traders/marketers closely follow the Energy Information Administration (EIA, http://www.eia.doe.gov/) on a weekly basis as they are in charge of collecting a variety of data and publishing that data on a weekly (Thursday 8:30 am MST), monthly and annual basis.

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AECO vs. Henry Hub

In Alberta, two prices are quoted and spoken of frequently, Henry Hub and AECO. Henry Hub is the American natural gas price which is quoted in million British thermal units (MMbtu) and is traded on the New York Mercantile Exchange (NYMEX). It is often referred to as the NYMEX price. AECO is the Alberta natural gas price which is quoted in gigajoules (GJ) and is traded on the Natural Gas Exchange (NGX).

Converting Henry Hub to an AECO equivalent is not as simple as converting the quoted prices from U.S. dollars to Canadian dollars, or vice versa. There are numerous factors which affect this conversion including foreign exchange rates, basis differential calculations which generally include the cost to transport gas through pipelines to other physical hubs, and unit conversions from million British thermal units (MMBtu) to gigajoules (GJ) to list a few.

Natural gas produced domestically in Canada is often sold to markets worldwide. For this reason, the currency conversion factor strongly affects the realized price for natural gas.

As a general rule, a $0.01 change in the Canadian Exchange Rate (holding Henry Hub and Basis Differential constant) results in a $0.065 change in the AECO Spot price. The relationship between these two factors is a negative correlation, meaning that if the Canadian Exchange Rate gains $0.01 against the U.S. Exchange Rate, the AECO natural gas price will decrease by $0.065.

It is often deceiving to witness one price increasing while its counterpart decreases, however the above mentioned factors are the cause of such movements. 

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Upward and Downward Pricing Pressures

Current Upward Pressures

  • Production: Many factors can influence production worldwide. Ultimately, if production in any way declines, supply in essence declines causing the price of natural gas to rise.
  • Economy: Strong economic growth in North America causes demand to increase, resulting in an increase in natural gas prices.
  • Hurricanes: Strong hurricanes can result in large amounts of production being shut-in, usually temporarily, which in turn lowers supply and increases demand, causing prices to rise. Hurricanes can also negatively impact demand.
  • Oil Prices: Elevated crude oil prices decrease the demand for oil, causing users to switch to natural gas, increasing demand and therefore price.
  • Weather: Extremely cold weather in winter and hot weather in summer can significantly increase natural gas demand which causes prices to rise.

Future Upward Pressures

  • Demand: North American natural gas demand is expected to increase in the future. Gas for clean power generation and for industrial processes, particularly for Alberta oil sands developments, accounts for most of the expected increases in demand.  Further demand increases are expected as North America moves towards more environmentally friendly fuels and clean energy alternatives.
  • Production: Despite increased drilling, conventional natural gas production and well productivity will continue to decline in the future as North American sedimentary basins reach increasingly mature levels of development. Unconventional sources of natural gas, like shale gas drilling, are in the early stages of technical development. New multi- stage fracture technology has improved the economics of unconventional shale and tight gas significantly.
  • Crude Oil Prices: Average crude oil price forecasts between $50.00 and $70.00 per barrel through to 2020 will provide steady support for natural gas prices.

Current Downward Price Pressures

  • Storage: Typically, natural gas prices and storage levels are inversely related.
  • Demand: Reduced demand normally results in lower natural gas prices.
  • Exchange Rate: Canadian natural gas prices and the Canadian exchange rate are inversely related.
  • Weather: Cold winters and hot summers typically result in higher prices, which in turn lowers demand for natural gas. This causes natural gas prices to fall as lack of demand causes storage levels to remain relatively high.

Future Downward Price Pressures

  • Liquefied Natural Gas (LNG): With the construction of liquefication plants globally, incremental increases in the future natural gas supply to North America is possible as imported liquefied natural gas will arrive in the North American marketplace if not purchased and consumed by other global markets.
  • Unconventional Gas Supply: Reduced conventional natural gas supply is expected to be largely replaced by increased unconventional natural gas, particularly coal bed methane and shale gas.
  • Arctic Gas: Both the Mackenzie and the Alaska natural gas pipeline proposals offer the potential to deliver significant quantities of natural gas to the North American market once they are approved and constructed.

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