The past few weeks have further reinforced my strong belief that the US is headed for an energy crisis epidemic proportions. While this might seem like a very bold statement, the facts more than support this argument. Even if one were to cast aside the improving, but still unstable, situation in Venezuela and the impending war with Iraq, it would become clear that America’s complacency with its energy supply is woefully unfounded.

Since current supplies are often the best indicator of future supplies and future prices, let’s examine what the US Department of Energy had to say in their weekly Petroleum Update for the week of January 31, 2003:

“U.S. commercial crude oil inventories (excluding those in the Strategic Petroleum Reserve) increased by 1.0 million barrels, but are 45.7 million barrels below the level last year at this time, and well below the lower end of the normal range for the end of January. Meanwhile, distillate fuel inventories plummeted by 10.3 million barrels, and are also now below the lower end of the normal range, as too are residual fuel inventories. Motor gasoline inventories fell by 3.4 million barrels last week and are now at or slightly below the normal range. Total commercial petroleum inventories, at 918.6 million barrels, are also below the lower end of the normal range.”

It should be noted that crude inventories in the US now stand at 28 years lows and at all-time lows on a days-available basis.

The oil workers strike in Venezuela is continuing to wreak havoc on the country. It has forced a country that was once one of the world’s largest exporters of crude and refined products to import gasoline to meet growing shortages. Despite government reports that the country is now producing nearly 2 million barrels a day, it is likely the country is producing closer to 1 million barrels a day. While some of the striking oil workers have broken ranks for fear of losing their jobs, many more remain steadfast in maintaining union discipline. While it is still unclear how the strike will end, it is becoming very apparent that significant damage has been done to Venezuela’s production capacity. The shutting in of many of the country’s aging wells over the past couple of months has destroyed the pressure required for these wells to continue to be productive. It will take months once the strike has been concluded to know the full extent of the damage. Early estimates indicate that as much as 500,000 barrel of equivalent per day (boed) of Venezuela’s production capacity has been ruined.

Since the loss of over 1.5 million barrels a day of production from Venezuela was not enough shock the world into the reality that the 21^st century’s first energy crisis is upon us, I have every confidence the upcoming war with Iraq will awaken the world to the new energy landscape. Based on Saddam Hussein’s threat to blow up Iraq’s and Kuwait’s oil fields at the first sign of attack, it would not be unreasonable to assume that the two countries would experience a complete cessation of oil production once hostilities begin. According to the Oil and Gas Journal, Iraq and Kuwait combined to produce 4.3 million barrels of oil a day in October 2002. This figure amounts to 5.5% of total worldwide production. (Source: Oil and Gas Journal, January 13, 2003. page 67.) Clearly a disruption in oil production from Iraq and Kuwait for any length of time will have a dramatic effect on the price of oil.  Many market observers believe oil can go to $40US if we go to war, other say $50US. Based on the tight world wide supply situation, I believe oil will go to at least $40US if the war is won quickly and easily. However, if my worst case scenario unfolds, we could be looking at $100US oil. 

In my view, there exist three scenarios that are likely to play out when the US begins hostilities with Iraq. The first and least likely scenario is one in which Saddam Hussein is defeated quickly and little damage is done to the oilfields of Iraq or Kuwait. This scenario has very little chance of occurring since Iraq is very much prepared to blow up its oil derricks once the invasion starts.  The second, and most likely scenario, is an invasion where the US defeats Hussein within a period of six weeks but massive damage is done to both the Iraqi and Kuwaiti oil infrastructure. I do not believe that there is a situation in which Hussein does not light his oil fields ablaze once an invasion starts. Along with the fact that he is unlikely to tolerate the idea of the Americans using his oil to set up a new government, Hussein will need to create some sort of cover for his army. Clouds of billowing black smoke will make tracking Iraqi troop movements significantly more difficult for US surveillance. The final scenario that might play itself out in Iraq is one in which the US gets into a protracted battle with Hussein and the worst case scenario unfolds. The war spreads to Saudi Arabia. If Saudi Arabia were to be destabilized and overthrown, similar to what occurred in Iran in 1979, the world would have a monumental problem on its hands. While I believe my worst case scenario is unlikely, its occurrence would triple the price of crude oil overnight.

So what does this all mean for investors in the Canadian energy sector? Two words: higher prices. Despite very high oil and gas prices in both Canada and the US, there has been only a modest upward movement in equity prices. This is about to change. The market for Canadian energy equities is currently priced for a collapse in oil prices once the situation in Iraq is resolved. Given today’s inventory levels, the likelihood of a collapse in oil prices is remote. The market is soon to realize that high oil prices are not a result of a war in Iraq but of dwindling supplies and increasing demand. Once this occurs, a broad based energy equity rally should ensue.

That Giant Sucking Sound…

Crude oil and refined products are not the only commodities that are in short supply these days. The US and Canada are experiencing record draw downs in their inventories of natural gas. This has caused storage levels in both countries to reach very low levels for this time of the year.

For the week ending January 31, 2003, US natural gas inventories stood at 1,521 billion cubic feet (bcf). This low level of inventory was reached after January saw the US withdraw a record 853 bcf of gas from storage. With inventories at 1,521 bcf and eight more weeks of winter storage draws, the US will get to dangerously low levels of natural gas by the end of March. If there is less than 850 bcf in storage at the end of February, look for the return of $10US natural gas.

The natural gas supply situation in Canada is even worse than in the US. For the week ending 1/31/2003, Canada had a withdrawal of 26.3 bcf from storage. Supplies now sit at 183.4 bcf. This level of inventory is usually not seen until the last week in March.  Never before has Canada experienced such low supplies of natural gas at this time of the year. Given the continued cold weather in Canada during the first two weeks of February, the 2/10/03 spot price on the AECO of $7.94C will easily be surpassed as Canada’s supply is drawn down to unprecedented levels.

With natural gas production likely to continue to drop another 2-3% in the US in 2003 and remain flat to down slightly in Canada,  the age of single digit natural gas prices will end shortly. $10C natural gas on the AECO is very likely within the next 60 days and $10US gas on the NYMEX is likely by November 1, 2003. I am making this prediction based on four factors.

First,  natural gas directed drilling will not ramp up quickly enough to stem the production decline until at least 2004. This will ensure that storage levels at the beginning of the 2003/2004 withdrawal season are at record low levels.

Second,  demand destruction is becoming more difficult. With many heavy users of natural gas having already moved operations to locations with cheaper natural gas, further destruction of demand will only occur at significantly higher prices.

Third,  there are no easy answers to the coming supply crunch. Many market observers and  politicians have pinned their hopes that North America’s supply situation will be alleviated by an increased reliance on imported liquefied natural gas (LNG).  I see several problems with an increased in reliance on LNG. The amount of money required to build additional LNG receiving facilities is unlikely to be raised in today’s environment. The recent revelation that El Paso Corporation is exiting the LNG business came as a shock to your editor. Apparently El Paso’s years of misallocating its capital into Enron-like activities has finally caught up to one of America’s largest players in the LNG market. The firm is selling off assets to reduce its mammoth $25 billion debt load.

El Paso is not the only participant in the LNG field that is having financial problems. On December 18, 2002 the Federal Energy Regulatory Commission (FERC) awarded Dynegy a license to build the first LNG receiving facility in the continental US in over 25 years. This new LNG receiving facility to be built in Hackenberry, Louisiana will be capable of receiving 1.5 bcf/day of LNG when it becomes operational in late 2006. Given Dynegy’s large and multiple financial problems, I have serious doubts they will be able to complete the project by the end of 2006. Look for the project to be significantly delayed if Dynegy were to file for bankruptcy.

Breaking News:  As I was finishing this month’s issue, Dynegy announced it was selling its Hackenberry, LA project to Sempra Energy for a paltry $20 million dollars and future considerations. Also the completion date of the project was pushed into 2007.

If natural gas prices rise over the $10 level in the US and Canada, there will be enormous pressure on energy firms and government officials to build a natural gas pipeline from the US/Canadian arctic to existing distribution networks. The two competing proposals, one Canadian and one American, would bring a combined 5 bcf a day of gas to North American consumers. However neither pipeline will likely be completed before the end of this decade. This is due to the highly political nature of the projects and their enormous cost. 

Fourth,  the final reason I believe we are about to usher in a period of double-digit gas prices is the fact that there are few large North American discoveries coming online. While the ultra-deepwater Gulf of Mexico and the East Coast of Canada are very promising natural gas basins, we are still several years away from harvesting significant production from these regions. Barring a big discovery near existing infrastructure, which is very unlikely since this is what every petroleum geologist is looking for, we have very little chance of drilling our way out of today’s natural gas supply situation.

© 2003 Bill Powers, Editor
Canadian Energy Viewpoint
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Bill Powers
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Information presented in this newsletter was obtained from sources believed to be reliable, but accuracy and completeness and opinions based on this information are not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein. The editor may have an interest in the companies mentioned. All data and information and opinions expressed are subject to change without notice.