Gas Producers, Users Mull Long-Term Deals Amid Output Boom

NEW YORK (Dow Jones), Sept. 30, 2009

A shift in the U.S. natural gas market could be approaching as producers consider cutting price volatility by inking long-term contracts with power generators and other big consumers.

Natural gas traditionally has been bought and sold at market prices with producers and major consumers using the futures market to smooth out big price swings. But producers remain exposed to sharp drops in gas prices, as seen over the past year, while price spikes can be costly for consumers.

Now, a huge increase in U.S. natural gas reserves, primarily from newly accessible rock formations known as shales, is changing the math, making longer-term, fixed-price contracts between producers and big consumers more feasible. Big U.S. gas producers, including Devon Energy Corp. (DVN) and Chesapeake Energy Corp. (CHK) in recent weeks have discussed turning to such contracts with major customers and investors.

"It is really very simple. Our industry discovered a lot more natural gas than previously thought," said J. Larry Nichols, chairman and chief executive of Devon Energy, in an interview this week.

Sharp gas-price swings have left the power industry reluctant to rely more heavily on the fuel, especially for so-called baseload generation that runs constantly and is largely provided by coal-fired and nuclear plants. The price volatility has been onerous enough to outweigh several advantages gas-fired plants have. Gas plants, which generate about 20% of U.S. power, are easier to site, cheaper to build and burn cleaner than coal, making them more attractive as the federal government inches closer to imposing limits on greenhouse-gas emissions.

In June, the non-profit Potential Gas Committee said the U.S. has 2,074 trillion cubic feet of gas available for production, nearly a century's worth of output at current rates. The estimate was a 35% jump over the last assessment, in 2007, thanks to the surge in shale-gas development.

The output boom has recently driven gas prices to their lowest in seven-and-a-half years, biting deep into producers' earnings. However, the surfeit of the fuel has also made gas producers more confident in their ability to meet longer-term obligations, with some saying they can provide generators with fixed-price contracts running as long as 20 years. With the new shale plays in Texas, Louisiana, Arkansas, Pennsylvania and other states coming online, producers are more certain of their costs, where they'll be drilling and the volumes they'll likely garner five years from now.

Devon's Nichols met this month with power company chief executives at an event hosted by the Edison Electric Institute, or EEI, an industry group. Steven Mueller, chief executive of gas producer Southwestern Energy Co. (SWN), said in an interview that his company has spoken with steel producers about long-term contracting. Both warned talks about long-term contracts are just beginning.

"I think gas producers are understandably enthusiastic, and I think we share some of the same enthusiasm," said EEI spokesman Jim Owen. He added power companies are interested in ensuring long-term supplies, though questions remain over the details, including prices.

Chesapeake Energy Chairman and Chief Executive Aubrey McClendon said at a conference last week that long-term contracts would likely involve a price collar, setting a limit on how high a producer could charge, and how low a consumer's price could fall.

McClendon said he's comfortable entering contracts for two to 10 years out with large consumers, adding energy companies are warily eyeing government proposals that could limit activities in the derivatives market, making hedging more difficult and long-term contracts more appealing.  

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