One of the first rules most analysts adopt early in their careers is never to give a price and a timeframe in the same sentence. As many readers are well aware, I do not shy away from making predictions about the direction of energy or currency markets and the timeframe in which these predictions will be met. In the October 2003 issue, I predicted that natural gas prices had hit their seasonal lows and were set to spike to over $10US during the winter. Well, winter has come and gone and we did not have a spike to over $10US. (December’s price surge only lifted prices into the $7.00US range.)  I did, however, manage to accurately predict that natural gas prices would turn sharply higher at a time when nearly all analysts were predicting that they would wallow in the low $4.00US range due to high storage levels. I bring this past prediction to your attention because the evidence that supported my prediction of a price spike last winter is even stronger today.

In this month’s issue I will examine the four reasons behind my thesis that we have entered a “new era” of natural gas pricing and what it means for investors. While I hate the phrase “new era” and all the ugly connotations associated with it, I could not think of better way to describe the sea change that I see taking place.

1)      Canadian production continues to fall.

According to the data provided by Natural Resources Canada in the below table, Canadian natural gas production has had a precipitous fall off in recent months. (In all of the below tables I have used data for the most recent 12 months currently available.)

  Canadian Natural Gas Production (BCF)*

What I find most interesting about the drop in Canadian production is that it has come at a time of historically high prices and record drilling activity. The below table contains the number of Canadian natural gas well completions each month over the past year and the percentage increase over the same month in the prior year. Once again, the data is provided courtesy of Natural Resources Canada.

  Canadian Natural Gas Wells Completed*

The drop off in Canadian production is having a significant impact on Canada’s natural gas exports to the United States. After 16 years of growing natural gas exports to the United States, 2003 witnessed a dramatic decline in exports. I fully expect this trend to continue. The table below contains data from the US Department of Energy and clearly displays the trend of declining Canadian natural gas exports.

 US Natural Gas Imports from Canada (MCF)*

2)      Rising Canadian demand.

While much has been made of the increase in natural gas consumption that is occurring due to oil sands production, I believe most market observers are unaware of other sources of Canadian natural gas demand growth. Dalton McGuinty, the recently elected Liberal Premiere of Ontario, continues to hold to his campaign pledge to close Ontario’s five coal-fired power plants by 2007. Ontario’s five very large coal-fired plants have a combined capacity of 7,519 MWh and produce 26% of the province’s power. I find it unlikely that McGuinty will be successful in shutting down the coal fired plants by 2007 due to the extreme tightness in the electricity market in Ontario (which suffered an enormous blackout last summer). Any effort to reduce Ontario’s reliance on coal fired plants would involve building substantial natural gas fired generating capacity.

 Canadian Natural Gas Consumption (BCF)*

In addition to the likelihood of increased natural gas demand from electricity generation in Ontario, demand is also set to rise rapidly as northern Alberta’s oil sands operators continue to ramp up production for the remainder of this decade. To put some numbers behind this statement, consider the following quote from a workshop draft put together by Natural Resources Canada in 2003 entitled “Oil Sands Technology Roadmap:”

“Oil sands projects are heavily dependent on natural gas used in burners or cogeneration plants to provide steam to separate bitumen from sand and produce electricity.  Natural gas is also the feedstock of choice or convenience to produce hydrogen for upgrading.  A rule of thumb; full recovery and upgrading consumes about 1,000 standard cubic feet per barrel.  Alberta Energy and Utilities Board (EUB) places reserves of natural gas as of 2002 in Alberta at 42 trillion cubic feet (TCF), with annual production of 4.8 TCF. Seventy-five percent of production was exported to other Canadian provinces or the United States. According to the EUB, natural gas usage by the oil sands industry in 2002 was approximately 142 BCF annually. This is projected to increase three times to 428 BCF by 2012 or an increase to 10% of Alberta production.”

(See section 1, “Oil Sands in a Changing World”,  page 9,  by Carol Fairbrother and Len Flint.  The entire document can be viewed at the following URL:  http://www.nrcan.gc.ca/es/etb/cetc/combustion/cctrm/pdfs/ostrm_draft_agenda.pdf )

3)      Falling US production.

There have been conflicting opinions about the true state of natural gas production in the United States. According to the US Department of Energy’s Annual Outlook, natural gas production in the US is expected to remain flat in 2004 at 19.5 tcf. (This document can be viewed at the following URL: http://www.eia.doe.gov/oiaf/aeo/pdf/aeotab_13.pdf) However, several Wall Street firms including Raymond James, Lehman Brothers and First Energy of Calgary have all come to the same conclusion that, based on a review of SEC filings of the 50 or so largest publicly traded natural gas producers in the US, production is set to fall 2-3% in 2004.

After reviewing a great deal of evidence, I believe US natural gas production has entered into a permanent and irreversible decline. US natural gas production is now on the down slope of Hubbert’s Peak and is likely to follow the trajectory of oil production after it peaked in 1970. However there is one very large difference between the production decline curve of oil and natural gas -- gas fields have been known to rollover faster than oil fields.  A very good example of an area that has entered into steep decline after years of stable/growing production is the Gulf of Mexico (GOM).

According to a recent presentation by Martin King of First Energy of Calgary, total GOM production has fallen from 14 billion cubic feet per day (bcf/d) in January 2001 to under 12 bcf/d in January 2003.  Mr. King sites US Mining and Minerals Management Services as his source.

I find the 14% decline in GOM natural gas production in two years (and its continuing drop) staggering. New deepwater projects are now only replacing production declines from existing projects and are no long adding any net production. Shallow GOM production, which makes up a majority of all offshore production, is not receiving the needed investment to hold off a rapid decline in natural gas production.

While many are hoping LNG and Arctic natural gas will solve the US natural gas supply shortage, these efforts will only be stopgap measures if the US domestic supply situation continues to deteriorate.

4)      Increasing US demand.

The most difficult aspect of the supply/demand puzzle is predicting future natural gas demand in the US. We can, however, make several inferences from available data.  The most interesting data point I have found in my research for this article is the increased electricity demand in the US over the last 16 weeks. This information is available to all in the “Market Laboratory” section of Barron’s each week (It can also be found in the ‘Pulse of the Economy’ section under the Market Lab title in Barron’s Online.) The below table clearly shows the increasing demand for electricity in the US.

 US Electricity Usage (in mil. kw hrs)*

*Source: Barron’s

Rising electricity demand in the US is a clear signal that natural gas demand is likely to increase during the summer months. Increased natural gas demand will in turn lead to much lower storage injections as the US prepares for the 2004/2005 winter heating season.

5)      Conclusions.

I believe this summer will shape up to be one of tremendous volatility for the North American natural gas market. While this should not come as a surprise, I believe this summer’s volatility will usher in a new pricing band for natural gas. With the very favorable fundamentals that currently exist, look for gas to put in a price floor of $6.50US by the middle of the summer and trade much higher as we head into next winter.

© 2004 Bill Powers, Editor
Canadian Energy Viewpoint
See Mr. Powers' Cover Page for Bio and Archived Editorials

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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.