 A
Conundrum - The Natural Gas Market
Bill Powers
Canadian Energy Viewpoint
December 20, 2004
The natural gas market
can easily be considered an enigma wrapped in a riddle. US storage
is at record levels yet prices are historically high. Drilling
is at record levels yet supplies are falling. There exists an
almost unexplainably large gap between natural gas spot prices
and futures prices. While the recent surge in crude prices can
be credited for some of the recent gains in natural gas prices,
I believe there are several unrecognized trends that are shaping
the North American natural gas market.
Soaring crude prices have significantly
increased the incentive for industrial users of distillates to
switch to natural gas where possible. For those unfamiliar with
the gas/distillate conversion ratio, a little background may
be helpful. The British thermal unit (BTU) content of natural
gas is approximately one-sixth the BTU content of oil. For example,
1,000 barrels of oil are equivalent to 6 million cubic feet (mmcf)
of natural gas. ($50US oil has an equilibrium price at 6:1 of
$8.33US). The price of crude oil has gone from trading
at a discount to the BTU content of natural gas for the better
part of the past two years to trading at a premium today. The
market is making adjustments to this new reality. Given the low
and declining inventories of distillates in the US, I expect
industrial consumers of distillates to continue to switch to
natural gas.
Another unrecognized trend
that is becoming a growing force in the North American natural
gas market is the increased stripping of natural gas liquids
(NGLs). Prior to natural gas entering a sales pipeline,
operators who produce natural gas with significant amounts of
NGL's are now encouraged to remove and sell them at premium prices.
According to the Raymond James' Natural Gas Market Update dated
November 4, 2004, gas processors are stripping the equivalent
of 1.1 billion cubic feet per day (bcf/d) of NGL prior to gas
entering the sales pipeline. Since NGL pricing is similar to
that of light crude, I expect liquids stripping to continue as
long as gas continues to sell at a discount to oil.
While I try not focus on the
vagaries of the weather, I feel a comment on the weather's impact
on the natural gas market is needed. One of least recognized
aspects of the North American natural gas market is the fact
that we have experienced bearish weather over the past 12
months but have had record natural gas prices. (In 2003,
NYMEX natural gas prices averaged a record $5.50 per thousand
cubic feet (mcf) and have averaged $5.84 per mcf to date in 2004
according to FirstEnergy Capital Corp.). The mild summer
of 2003 was followed by a slightly warmer than normal winter
and another extremely mild summer in 2004 in many parts of the
country. While it is impossible to predict the weather for this
winter's heating season, a return to normal winter weather will
likely cause a spike in natural gas prices.
Any discussion of weather would
not be complete without mentioning the impact Hurricane Ivan
has had on Gulf of Mexico (GOM) natural gas production. Hurricane
Ivan has been called the costliest hurricane in the history of
the energy industry. I tend to agree with this analysis. According
to the Minerals Management Service, a division of the US Department
of Energy that oversees US Outer Continental Shelf (OCS) offshore
production, total lost production from when Ivan entered the
GOM on September 10th to November 11th was 28.9 million barrels
of oil and 116.9 billion cubic feet of gas (bcf). Lost production
to date represents 4.78% of OCS annual oil production and 2.63%
of annual OCS natural gas production. There still remain 205,000
barrels of oil per day (bopd) shut-in and 700 mmcf/d of natural
gas offline. While both of these figures are down significantly
from those reported immediately following the storm, it will
take several more months before all storm damage can be repaired.
Probably the most important
reason to expect to see North American natural gas prices continue
to escalate is that production continues to decline. US natural
gas production continues to fall despite record drilling activity.
Canadian production is up only slightly in the first half
of 2004. According to Natural Resources Canada, in the first
six months of this year, we have seen a record number of natural
gas wells completed but production was up only .66%.
Canadian Natural Gas Wells
Completed 2004*
| Month |
Wells
Completed |
%
Change Same Month 2003 |
| January |
1,659 |
107% |
| February |
665 |
8% |
| March |
1,192 |
20% |
| April |
1,511 |
55% |
| May |
1,258 |
63% |
| June |
998 |
23% |
| *Source:
Natural Resources Canada |
Canadian Natural Gas Production
2004*
| Month |
Production
(bcf) |
%
Change Same Month 2003 |
| January |
536 |
-1% |
| February |
489 |
2% |
| March |
505 |
-3% |
| April |
495 |
2% |
| May |
490 |
3% |
| June |
458 |
1% |
| *Source:
Natural Resources Canada |
The above tables clearly indicate
that well productivity (i.e. the amount of natural gas that each
well produces) continues to decline -- a clear indication that
the natural gas treadmill is accelerating in Canada. More importantly,
there is strong evidence to suggest that the wet weather that
hampered drilling activity in Western Canada throughout the summer
drilling season is resulting in rapidly declining field receipts.
I believe a substantial drop-off in Canadian production will
result from these weather-related drilling delays and cause a
total 2004 Canadian natural gas production decline from 2003
levels.
While Canada's record drilling
during the first half of 2004 resulted in slightly higher production,
US natural gas production continues its relentless decline. Results
from a survey of 46 large US publicly traded natural gas producers
conducted by investment firm Raymond James indicate that Q3 2004
production dropped 3.3% from Q3 2003 levels. This drop is even
more remarkable considering the 13% increase in natural gas directed
drilling activity. According Baker Hughes, a record 1,068 rigs
actively drilled for natural gas in the US in October 2004 compared
to only 941 rigs in October 2003.
Further adding to the case
for strong North American natural gas prices is the escalating
costs for natural gas drilling. After listening to scores of
third quarter conference calls and reading dozens of quarterly
reports, nearly every operator is experiencing escalating drilling
costs. Higher rig day rates, escalating land costs and pricey
acquisitions are all contributing to the slow expansion of drilling
activity.
Possibly the best example of
the impact of escalating costs came on EnCana Corporation's (TSX:ECA)
third quarter conference call. It should be noted that ECA is
North America's most active natural gas driller and is expected
to produce approximately 1 trillion cubic feet (tcf) in 2004.
The first question in the Q&A portion of the call was from
an analyst who asked whether ECA would increase their capital
expenditure program in 2005 due to higher costs. ECA's Chief
Operating Officer Randy Ehrsman said that the company has built
into its 2005 spending program a "10 to 15% cost inflation"
and the higher costs will result in less activity. With
ECA's intense focus on capital discipline, much to the delight
of Bay Street and Wall Street, I strongly doubt the company will
increase its capex program regardless of natural gas prices.
Where do prices go from here?
While I believe we will continue to see a very high degree of
volatility in natural gas prices, the strong fundamentals of
the North American natural gas market suggest we are likely to
see natural gas establish a new trading range between $8 and
$10US within the next 6 to 12 months. Savvy investors should
overweight their portfolios to natural gas focused independent
producers with a strong emphasis on the faster growing junior
producers.
written December 1, 2004
Bill Powers
Editor, Canadian Energy Viewpoint
Email: bill@canadianenergyviewpoint.com
Website: www.canadianenergyviewpoint.com
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321gold Inc
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