Supply Chain Management Review

Robert A. Rudzki

Supply Chain Components of Natural Gas Cost – II
June 24, 2008

Today’s guest blogger is Peter Franolic, who heads the Energy practice at Greybeard Advisors LLC. Pete is the former Director of Energy Affairs for one of the largest energy users in North America, where he managed all aspects of energy, including energy procurement, risk management and hedging, conservation, and regulatory matters, before joining Greybeard. Pete can be reached at: Franolic@GreybeardAdvisors.com

This is the second in a multi-part series that will run over the next few weeks.

Exploration and Production or Wellhead costs

There are hundreds of producers in the natural gas industry. But they all perform essentially the same function in acquiring their product to sell to the market. Wellhead costs include:

• expenditures that involve the exploration for gas using state-of-the-art seismic technology
• drilling actual gas wells to extract gas
• completion and longer term production from the well

There are risks involved in each of these processes as there is never 100 percent certainty that gas will be found. Additionally, newer drilling technology as well as the need to drill in inhospitable or inaccessible locations (think Alaska North Slope or Gulf of Mexico) can add significant cost. The price of gas has to recover this cost as well as the risk premium that is involved.

The price of natural gas at the wellhead is the most volatile component in the supply chain. It is the piece of the total cost that “floats” with supply and demand fundamentals as well as the influence of speculators.

But the true well price is not what is reported in trade newsletters such as “Natural Gas Daily” or Natural Gas Intelligence.” The reported price will have additional embedded fixed costs, primarily the gathering, processing and transportation required to reach a “Market Hub.” The Market Hub is where the natural gas is traded and where there is enough volume changing hands to create the liquidity necessary to have price transparency.

Gathering

Once a well is producing, the gas needs to be moved to the next step in the process to get to market. In most instances, a producing well is part of a larger producing field that consists of many, sometimes hundreds of producing wells. All of these wells need to be drained of their production by a natural gas gathering system that collects and moves the gas to various processing facilities. It is economical to collect gas from wellheads in this manner and deliver to a large common processing facility rather than try to treat each individual well. 

A complex gathering system can consist of thousands of miles of pipes, interconnecting the processing plant to upwards of 100 wells in the area. Gathering systems can be owned by the wellhead owners, the processing plant owners or by independent third parties. The cost of the gathering system becomes a fixed adder to the price at the wellhead and in most circumstances is set by tariff. 

According to the American Gas Association, there are more than 37,000 miles of gathering system pipelines in the U.S.

Processing

The natural gas used by consumers is composed almost entirely of methane. However, natural gas found at the wellhead and delivered by the gathering system, although still composed primarily of methane, is by no means as pure.

Whatever the source of the natural gas, it commonly exists in mixtures with other hydrocarbons; principally ethane, propane, butane, and pentanes. In addition, raw natural gas contains water vapor, hydrogen sulfide (H2S), carbon dioxide, helium, nitrogen, and other compounds.

Natural gas processing consists of separating all of the various hydrocarbons and fluids from the pure natural gas, to produce what is known as 'pipeline quality' dry natural gas.

Major transportation pipelines usually impose restrictions on the make-up of the natural gas that is allowed into the pipeline. That means that before the natural gas can be transported it must be purified. Accordingly, the ethane, propane, butane, and pentanes (known as Natural gas Liquids-NGLs) must be removed from natural gas. These NGLs are sold separately and have a variety of different uses; including enhancing oil recovery in oil wells, providing raw materials for oil refineries or petrochemical plants, and as sources of energy.

Again, the cost of processing natural gas is primarily fixed and cannot be avoided.

The output of the processing plant is “pipeline quality” gas and connects to the interstate pipeline system and “market hubs.” It is at this point that end users and marketers can interface with the market. It is also at this point that the price of natural gas can be termed “commodity cost.” But as mentioned earlier, the gathering and processing costs are fixed quantity components of the total commodity cost.

In the next segment of this review, we will discuss the interstate pipeline system and local distribution systems and the role they play in the total cost of natural gas.

Posted by Robert A. Rudzki on June 24, 2008 | Comments (2)