from Energy, Security, and Climate and Energy Security and Climate Change Program

What If We’re Wrong About Natural Gas?

February 07, 2012

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Most analysts are incredibly bullish about the prospects of shale gas production in the United States. An early preview of the annual U.S. government energy projections, released last month, sees U.S. gas production rising steadily for decades. Petrochemicals producers are building new plants, and other industrialists are conjuring schemes for exporting the fuel. Security hawks dream of compressing the gas and putting it into cars and trucks so that the United States can use less oil. Some environmentalists are relieved that gas will back out coal and thus cut carbon emissions.

But what if we’re wrong? I’m not saying that I buy the various arguments out there that claim to show that shale gas reserves are grossly overstated or that shale gas economics is a crock. But energy is an uncertain space that regularly hands out surprises (like, um, shale gas). Relatively immature areas like unconventional gas deserve special care. Moreover, even if the economics of shale gas hold up, public opposition to drilling could curtail supplies.

There’s one natural response to this possibility: So what? Private investors are risking their money on shale gas production. Private landowners are leasing their properties. Private chemicals firms are building facilities that depend on abundant supplies of cheap gas. Yes, if the natural gas glut turns out to be less than advertised, they’ll lose money. But investors lose money all the time. There doesn’t seem to be much reason that policymakers should care.

That’s true up to a point. But there are several areas where wrong projections could, in principle, have troubling public consequences:

Power Plant Regulation. Policymakers are currently considering a range of regulations aimed at reducing pollution from coal fired power plants. These rules, aimed in particular at curbing greenhouse gas emissions, are typically crafted with the aim of ensuring that their benefits exceed their costs. But their estimated costs depend on the alternatives available. In particular, abundant gas makes stringent regulations look less expensive, and hence makes them more likely to be adopted.

What happens, though, if that gas turns out to be a mirage? Aggressive regulations based on an expectation of cheap gas could drive coal fired power plants to shut down early; gas plants would take their place; if gas supplies then fell, people would be stuck with expensive gas, since they’d have gotten rid of the immediate alternatives.

Some may think that this is still a good outcome – after all, aren’t coal plants dirty? – but, at a minimum, it’s one that should be reached deliberately, not by mistake. Moreover, depending on the details, there’s probably a case for arguing that it’s an outcome we want to avoid.

Natural Gas Exports. Several firms have recently applied for permits to export natural gas. Some people worry that the combination of exports and domestic production shortfalls could be economically devastating. My instinct says that this danger is overstated.

If U.S. gas production doesn’t meet expectations, domestic prices will rise, and exports will become less economically attractive. To be certain, preexisting export facilities involve sunk costs and thus will have their own momentum, but scary economics are still hard to line up. The capital costs of a liquefaction facility work out to be a bit less than a dollar as much as $1.50 per thousand cubic feet of natural gas. So long as export contracts are closely linked to U.S. gas prices – the U.S. government should probably insist on this – economics should prevail.  As a result, except in a narrow set of circumstances (i.e. that one sunk dollar or so tips the balance between keeping gas at home and exporting it), the fact that export facilities already exist won’t have much impact on whether gas is used at home or sent abroad. After all, the fact that import facilities already exist hasn’t made anyone ship gas to the United States against their economic interests.

Large Capital Investments. One might worry, in a similar vein, that people will overbuild gas-using equipment (such as chemicals plants) only to later find gas supplies scarce. If that equipment is expensive, and gas remains a relatively small part of its owners’ costs, then those owners will presumably continue demanding gas despite rising prices. This will leave less fuel for others – and hence those others will face higher prices.

This all makes sense, but with a big caveat. We’re talking about enterprises in which gas would remain a relatively small part of costs even given rising prices. (That’s why they won’t shut down.) These are generally not the sorts of enterprises that will get created in response to low gas prices in the first place. As with export terminals, there might be a sweet spot in which sunk costs create their own momentum, but that sweet spot is probably small.

Renewable Energy Development. Low natural gas prices are apparently deterring deployment of renewable and nuclear energy, and hence learning and innovation in those sectors. This is a problem regardless of whether gas is scarce or abundant, since reasonably ambitious climate policies will require sequestration of carbon dioxide (including from gas use) or a strong shift to renewable and nuclear power within a couple decades or so. But it is an even bigger problem if natural gas supplies turn out to underwhelm, since in that case, the need to shift to zero-carbon sources would become even more pressing and sudden. This simply reinforces the case for ensuring that prudent deployment of and innovation in zero carbon energy receives solid public support even if the market currently prefers natural gas.

Crosscutting Lessons. There are two big bottom lines to this whole analysis.

First, the biggest public risks associated with overestimating natural gas potential appear to arise when governments get involved. If private players bet their money on the prospect of cheap gas, they’re the ones who will lose if they turn out to be wrong, but if government creates regulations based on similar assumptions, the public is more likely to end up on the losing end. In the climate space, that’s yet another reason why carbon pricing is so much smarter than rigid regulation – it doesn’t require nearly as much in the way of assumptions.

Second, cheap natural gas probably introduces bigger risks when it leads people and firms to foreclose options than when it leads them to expand choices. Policies that shutter existing power plants, or economic incentives that retard energy innovation, introduce bigger public risks than policies that allow new export facilities, or economic incentives that lead people to build petrochemicals plants.

Policymakers certainly shouldn’t make policy based on an expectation that the shale boom will turn into a bust. But that doesn’t mean that they should ignore real risks. It would be wise to keep the consequences of being wrong in mind as they move forward.