Bandwagon Gas Market

The “me too” philosophy common in the power generation business is again beginning to take its toll. In the late 1960s and early 1970s, power industry predictions showed that most new plants would be nuclear powered with the technology achieving a 50% market share by the early part of the 21st century.

In the 1990s, conventional wisdom held that the vast majority of new power plants built in North America would be natural gas fired combined cycle plants. It is now widely known that the first prediction was wrong; it should be increasingly apparent that the second was also based on false assumptions.

It might be useful to briefly discuss the similarities in the two experiences.

In literature about the nuclear power industry, the years between 1963 and 1967 are often called The Great Bandwagon Market. In 1963, there existed just a handful of operating plants, all of which received some subsidy from the Atomic Energy Commission. By the end of 1967, there were 75 plants on order with a nameplate capacity of 45 Gwe, none of which qualified for support by the AEC.

By 1973, most utilities had decided that they could no longer justify new orders and some began canceling projects that were already in progress. By 1979, when the accident occurred at Three Mile Island, nuclear plant orders had already ceased.

A major reason for the market slowdown was that the analysis supporting the orders turned out to be based on flawed assumptions. Instead of getting cheaper per unit capacity, the final cost of the plants increased rapidly. Instead of electricity demand continuing to grow at a steady 7% per year, it fell after the 1973 Arab Oil Embargo.

Instead of plants taking four or five years to build, they began taking eight or 10. Finally, instead of the plants achieving capacity factors of close to 90%, they were plagued with operational difficulties that caused unplanned outages.

A contributing factor in all of the above problems was that the rush to purchase nuclear plants strained the ability of the suppliers to meet their promised performance.

Component prices and lead times increased, labor became more expensive, engineers and managers got very busy, and raw material costs rose as demand outstripped supply. History seems to be repeating itself, but the star is now the natural gas heated combined cycle gas turbine (CCGT) plant.

Nearly every major power project announced in the past half dozen years has used that power plant design with an estimated increase in capacity rivaling that of the nuclear bandwagon market.

Turbine prices are increasing, delivery and installation schedules are lagging behind predictions, and reliability problems are becoming apparent. However, the major assumption that justified the choice is the one that has suffered the most from the most recent Great Bandwagon Market.

Contrary to all stated assumptions, natural gas prices have not remained predictably low. Instead, the fuel now costs about four times as much as it did just one year ago. In California, the cost of natural gas has increased by a factor closer to 10.

The delivered cost of fuel accounts for 75% to 80% of the cost of electricity produced by combined cycle gas turbines. Even under optimistic assumptions, it takes about 6,500 BTUs of natural gas to produce a kWh of electricity. At the recent price of about US$10 per million BTUs, the fuel cost alone for a modern CCGT operating adjacent to a major gas distribution hub would be 6.5 cents per kWh.

That is far in excess of the 4 cents per kWh routinely featured in the economic cases used to justify the plants, and it does not include capital, operations and maintenance or fuel delivery costs. It is also well above the 4.5 cents to 5 cents per kWh computed for a modern coal or nuclear power plant at the time that the combined cycle gas turbine was anointed as the power plant of choice.

The problem is a textbook case of what happens when a commodity whose supply is difficult to increase meets growing demand from customers without much flexibility. To allocate the limited available supply, the commodity price must increase to a point that will cause some demand to disappear. At nearly US$10 per million BTU, customers with any flexibility are curtailing their purchases.

Some of the customers being forced to leave the natural gas market have fewer choices than the generating companies that are replacing them. Several fertilizer companies using gas as a feedstock have already stopped production; they are no longer competitive with manufacturers in countries where gas is still cheap.

When leaders in the power industry chose the conservative course of action and decided to build the same kind of plants as everyone else, they incorrectly accounted for the risk that increased demand would increase fuel prices. Though each plant might have been a minor player in the market, the aggregate new demand by the electricity sector has been significant.

Commodity prices rarely follow inflation trends when there are fundamental shifts in the supply and demand balance.

Basic economic theory tells us that higher prices encourage new supplies, but the introduction rate will be limited because new sources of gas require large capital investments and significant lead times. In the natural gas business, there are several other factors that will constrain the rate at which new supplies are made available.

Skilled labor supplies are strained, available drilling equipment is fully leased, production companies are cautious, some prime drilling prospects are currently off-limits and construction projects to create new delivery systems are always contentious. Imports from countries other than Mexico and Canada are difficult and coal is not an alternative fuel for a gas turbine.

Though current gas prices are probably not sustainable, it is unlikely that prices will soon resort to levels close to the US$2 per million BTU used to justify the decision to build combined cycle gas plants.

If history is any guide to the future, expect some gas fired generating plants to be canceled. Bandwagon markets have a way of coming to a rapid halt when the flaws in the assumptions causing them are exposed.