The future of natural gas

NEW YORK (Fortune) -- Think oil prices are volatile? Well, check out the price swings for natural gas.

Natural gas hit $14 per mm/btu in the aftermath of Hurricane Katrina in 2005 and then confounded experts by dropping all the way to $6 the following winter. Prices soared to $8.50 last summer and then fell as low as $3.50 in fall 2006. So far this year prices have hovered around $7.50.

The reason natural gas is so wild is it's a captive market. For the most part, the gas that's produced in North America is what's consumed here, and vice versa.

There's little in the way of imports or exports, which means that a sudden decline in supply (caused, for example, by a hurricane sidelining some Gulf of Mexico drilling rigs) or an unexpected drop in demand (a mild winter in northern climes) will wreak havoc.

Donald Felsinger, CEO of the California gas and electricity company Sempra Energy, thinks the solution is more imports of the huge natural gas supplies now stranded in regions of the globe where the gas can't be used.

Sempra (Charts, Fortune 500) is building two tanker terminals - one in Baja, Mexico and the other in Louisiana - that will receive imported liquefied natural gas shipments. The company has permits to build a third in Texas.

Felsinger recently spoke with Fortune Magazine senior writer Jon Birger.

Question: The four existing terminals in the United States were operating well below capacity last year. Why are you so convinced the demand will be there for your new ones?

Answer: The market fundamentals have not changed from the beginning of this decade, when we saw prices around $2.50. The United States is consuming more natural gas than it produces.

The reason those [existing] facilities ran at half capacity last year is that liquefied natural gas went to other continents like Asia and Europe instead of to the United States. Even though our prices were in the $7 to $8 range, Spain, for example, was paying $14 or $15.

Question: And that's changed?

Answer: Yes. If you look at the first quarter of this year, my understanding is that all the existing terminals are operating at capacity because the prices have fallen in Europe and Asia. We are now getting that gas flowing to North America, where our prices are now higher.

Long-term, there is so much stranded gas around the world that doesn't have a market. This gas can be produced and liquefied and delivered to Asia or North America in the $4.50 to $5 range. Liquefied natural gas is the cheapest source of supply we have. The cost of drilling new wells is much higher.

Question: U.S. natural gas consumption has declined somewhat in recent years [2 percent since 2003]. Why do you a big pick-up in demand?

Answer: We had been forecasting internally that demand for natural gas would increase 1 percent to 2 percent a year, and I saw that the Energy Information Administration - the federal forecasting entity - has now revised its forecast upward to 3.4 percent.

A lot of this is driven by people's perception of what's going to happen with climate change. Among fossil fuels, the predominant generators of electricity are coal with about 50 percent of the market and natural gas with about 20 percent. [Nuclear makes up another 20 percent, with oil, hydro and other renewable sources accounting for the balance.]

Because natural gas produces about half the carbon footprint of a coal-fired plant and about 30 percent less than oil, natural gas is going to be the fuel of choice for power generation going forward.

In almost every quarter, people are talking about the need to produce more gas supplies and to get these prices that are forecast in the $7 to $10 range back to something that is more bearable to the consumer. Liquefied natural gas appears to be the only solution that can meet that cost objective.

Question: Shifting gears a bit, earlier this month you reported some not-so-great first-quarter earnings. What happened?

Answer: Just the opposite, they were great.

There's an accounting quirk in our commodities trading business, whereby if I agree to sell you a commodity for $5 at a future date, I can't book that profit [or mark the position to market] until you actually give me the money, even though we have a contract in place. We had a great first quarter, but because we had $80 million in profits that we couldn't record till later this year, people perceived that our business was down when it was right on target.

We reaffirmed our annual earnings guidance because this money is coming, just later in the year.

Question: Are you surprised by the keen consumer interest in fluorescent light bulbs these days - both as a money saver and as a way they can cut carbon gas emissions?

Answer: Fluorescent bulbs are in a breakout mode right now, in part I think because the light quality and the startup time today is so much better than it used to be.

At some point in time, I suspect incandescent bulbs will either have to change radically or be overtaken by fluorescent, which have so much lower energy consumption for the same amount of light output. And they last eight to 10 times longer.

Question: Out of curiosity, how much of the electricity we use is for lighting.

Answer: In a home, it's a very small percentage. The biggest user in any home is a the refrigerator and freezer, followed by pool pumps and air conditioners.