The Implications of an Oil Price Collapse on Natural Gas Rates

Declining oil prices could lead to increased natural gas commodity rates in the future. At first glance, this is counter-intuitive. Why would decreased oil prices potentially lead to increased natural gas prices in the future? In order to understand this puzzle, one has to understand some basic facts about the crude oil market. On April 20, 2020, oil prices in the United States were negative. The price of crude oil dropped to negative $36 per barrel at the West Texas Intermediate Hub (WTI), which is the hub used to benchmark oil prices in the United States. For a short period of time, entities were being paid to take delivery of crude oil in Texas. This is highly unusual. Crude oil normally has an economic value.

The WTI is a major market for crude oil, composed of an interexchange for multiple pipelines across the US. When someone says that oil prices have declined in the US, one is typically referring to a decline in prices at the WTI. The hub is a major pricing point for the futures market. “Futures” are contracts, where one party agrees to buy a commodity (in this case, crude oil) at a future date and at a specified price. Corporations exchange future contracts to reduce their crude oil expense at a future date. Investors exchange future contracts to earn money by trading crude oil contracts. The crude oil futures market reduces the volatility of crude oil prices for consumers.

Demand for crude oil decreased in 2020 after the US economy was largely shut down, due to COVID-19. Suppliers overproduced crude oil relative to actual demand for the commodity. Initially, the crude oil was placed into storage for future consumption. But over time, storage reached capacity and additional crude oil storage was unavailable. Crude oil has little to no value unless it has been refined. Someone had to take the excess supply. In response to overproduction and a turbulent futures market, crude oil prices went negative, which means that consumers were paid to take on the product.

What is the link between crude oil and natural gas?
Natural gas is extracted from the ground using a variety of methods, but falls into two general categories: associated, and non-associated. Non-associated gas comes from natural gas and condensate wells, whereas associated gas comes from wells that also contain oil. Crude oil is the primary product extracted from associated wells, and oil and gas extracting companies sell the associated natural gas as a byproduct of the crude oil. If oil prices increase, there are more oil wells that are profitable to operate and develop, which can also produce natural gas. In the past decade, natural gas consumers have benefited from increased supply of natural gas. If oil prices do not stabilize, there is concern that oil producers will stop production, which will decrease associated natural gas production; this could lead to increased natural gas prices in the future.

At the time of this blog’s writing, oil prices are no longer negative, and the price of crude oil has slightly recovered. Natural Gas prices are at record low levels. However, oil and gas extraction companies are currently on shaky financial footings. Many oil and gas companies have been downgraded in credit ratings and have faced increased financing costs from outside investors. If another demand shock hits the crude oil market, it would not be surprising to see more oil company bankruptcies.

Customers of Avista, Cascade, and NW Natural benefit from natural gas storage and hedging programs that reduce the volatility of natural gas prices. Sharing bands are another mechanism that stabilizes prices. Each year when gas costs are adjusted, they are set based on the following year’s estimated prices. In late summer, regulators look back at the previous fiscal year and evaluate the difference between those estimated costs and what prices actually turned out to be. The difference between the two values is subject to a sharing band wherein the utilities absorb a portion of the cost difference (whether positive or negative) and the remainder is absorbed by customers. Utilities set the sharing band year after year; for the past several years the band has been set at 10 percent. For example, say that gas prices in the current year are estimated at one value, and next year the costs turn out to be $1 million higher. Oregon’s gas utilities would share $100,000 of that cost, and the remaining $900,000 would be added to customer rates. If the cost difference were $1 million less than the estimate, on the other hand, the utilities would absorb their share as revenue and customers would see an equivalent rate reduction.

Despite these mechanisms that help stabilize gas prices, CUB does not have enough information to predict what will happen to natural gas prices in the future. As with so many circumstances in the COVID-19 era, the future of natural gas prices is uncertain. But readers can rest assured that CUB will continue to work hard to protect your interests and keep residential gas rates affordable.

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