One of the most popular supply solutions put forth to remedy the coming North American natural gas crisis has been the building of natural gas pipelines from the US/Canadian Arctic to the North American gathering system. While some market observers believe the combination of US and Canadian Arctic natural gas, along with imported liquefied natural gas (LNG), will provide enough supply to keep natural gas prices near today’s levels, there is substantial evidence to indicate that Arctic gas will not come online in time to avoid a natural gas crisis. In this issue we will examine many of the facts surrounding Arctic natural gas and what it means for investors.

The North Slope of Alaska is home to one of the last great frontiers for North American natural gas. The area has been a prolific oil producing region for decades and according to the US Geological Survey is home to at least 35 trillion cubic feet (tcf) of natural gas. However, since there is not a ready market for the gas in Alaska or northern Canada and there is no pipeline in the area, the gas is considered stranded. While exploration and production companies are not able to book stranded gas as reserves, that does not mean the gas has no value. In fact, there is enough value for owners of arctic acreage to consider building very expensive pipelines to the North American gathering system.

During the last natural gas crisis in the 1970’s there were plans to build a natural gas pipeline from the Alaskan North Slope to the US Midwest. Unfortunately, by the time the project got off the ground, new legislation in the US led to greatly reduced demand and much lower prices. In 1978, President Jimmy Carter signed two acts, the Power Plant and Industrial Fuel Act and the Natural Gas Policy Act, which were both designed to bring relief to a very tight natural gas market in the US. The Power Plant and Industrial Fuel Act outlawed the use of natural gas for electricity generation and required utilities to burn coal and the Natural Gas Policy Act deregulated prices. Apparently, Jimmy Carter’s new initiatives worked better than expected. Almost immediately after the two acts became law, supplies of gas began to swell. The following was taken from “The Oil Follies of 1970-1980” by Robert Sherrill:

“And yet less than sixty days after that signing, the White House was complaining about a “gas bubble” – surplus - of one trillion cubic feet and acknowledging that the bubble might last at least two to three years. Energy Secretary Schlesinger in January wrote state regulatory commissions urging them to encourage more residential hookups to natural gas systems. The same month in a speech to Wall Street oil analysts, Schlesinger said, ‘Although the Administration remains committed to the use of coal instead of oil or gas in new boiler facilities over the longer run, over the course of at least the next several years, existing industrial and utility facilities will be provided every encouragement to burn gas instead of oil.'

To complete the irony, the DOE [US Department of Energy] soon changed the formula by which natural gas prices were being decontrolled; to encourage industrial users to slop up the surplus bubble, the formula was rewritten so that they would have to play less and homeowners more.” - Page 469 “The Oil Follies of 1970-1980” Robert Sherrill

The natural gas situation we are faced with today is far different from the situation nearly 30 years ago when the first proposals were written to build an Arctic natural gas pipeline. The US and Canada no longer have significant undeveloped acreage positions that will become economic with the right regulatory environment (i.e. section 29 credits) or the right price. Canadian and lower-48 natural gas production is in permanent and irreversible decline regardless of price. This fact, combined with the increasingly inelastic demand for natural gas from the electrical power generating industry and the difficulties in expanding LNG imports, leads me to conclude that at least one natural gas pipeline from the US/Canadian Arctic will move forward to completion.

Alaska Highway Project

There have been two competing proposals brought forward that would bring natural gas from the US/Canadian Arctic region to consumers in the lower-48. Operators of the Prudhoe Bay field in Alaska (ExxonMobil, BP and ConocoPhillips), along with a consortium of pipeline operators (which includes Mid-America Energy, a division of Berkshire Hathaway) have proposed building a 1,700 mile pipeline that would follow the Alaskan Highway south into the Yukon Territory of Canada before connecting to the Trans-Canada gathering system in Alberta. This pipeline system, often referred to as the Alaska Highway natural gas pipeline, would have an initial carrying capacity of four billion cubic feet per day (bcf/d) of natural gas and a hefty price tag of approximately $8.3US billion. (Source: “The Imperatives of Arctic Natural Gas Development.” Oligney and Longboat, 2001)

Mackenzie Valley Pipeline

In 2002, Imperial Oil, ConocoPhillips, Exxon Mobil, and Shell Canada formed the Mackenzie Gas Producers Group with the aim of developing the Mackenzie Delta natural gas fields and constructing a pipeline system along the Mackenzie Valley . According to the Canadian Association of Petroleum Producers, there are 10 tcf of natural gas reserves in the Mackenzie delta area. This system would begin in the Mackenzie Delta area, follow the  Mackenzie River and deliver gas to northwestern Alberta where existing pipelines could move the gas to other parts of Canada as well as the United States. The goal is to have the natural gas moving through the pipeline by 2010. The 1,040 mile pipeline is planned to have a 1.2 bcf/d initial capacity that could be expanded to 1.9 bcf/d by adding additional compression stations. The overall cost of the project, including the construction costs of the pipeline, the gathering system and required field development is estimated at $4C to $5C billion or $3US to $3.8US billion. (Source: US DOE)

In addition to the Mackenzie Producers Group, the Aboriginal Pipeline Group (APG) will also have an interest in the pipeline portion of the Mackenzie Valley project. The APG was formed in 2000 to represent the interests of the aboriginal people of the Northwest Territories in the project. The APG has signed a “Memorandum of Understanding” with the Mackenzie Gas Producers Group that gives APG the right, depending on the throughput of the pipeline, to own up to one-third of it. Also, as part of the Memorandum, TransCanada Pipeline Corp. (TSE:TRP) will lend approximately $60US million to the APG to finance APG’s share of the project planning costs. The APG expects to finance the vast proportion of its share of the pipeline construction costs by borrowing against its share of future pipeline revenues.

While the Alaskan gas pipeline project continues to suffer from infighting among the producers group over whether the project should receive government subsidies (ExxonMobil is against a US federal government subsidy of the project while its partners are not), the Mackenzie project appears closer to the beginning of construction. With the feasibility phase of the Mackenzie Gas Project completed in 2001, the project is now in the project definition phase. This phase, which is nearing its completion, has involved community consultations, engineering and environmental studies and the preparation of a preliminary information package that was submitted in June 2003 to regulatory authorities.

At the end of the project definition phase, the developers, led by Imperial Oil, will reassess the project, taking development costs, fiscal and royalty regimes, as well as market and economic conditions into account. Given today’s high price of natural gas on both the AECO and the NYMEX, the economics of the project fully support the decision to move to the construction phase.

If the project moves forward, pre-construction activities related to the Mackenzie project are expected to take place in 2006 and 2007. Construction is expected to take two consecutive winter seasons and is planned for the first four months of 2008 and 2009. Construction will include drilling and exploration at three known natural gas fields in the Mackenzie Delta: Taglu, Parsons Lake and Niglintgak. Development drilling within the natural gas fields is planned to start in 2007 and continue until 2009.

After the construction phase, the pipeline operation phase will follow. A natural gas gathering system and the main Mackenzie Valley pipeline system will include compressor stations and natural gas liquids facilities. Once the pipeline has gas wells tied into it, the line should operate for a 25-year lifetime. More exploration in the Arctic will be encouraged by the prospect of being able to sell the found gas. (Source: Opportunities North)

While a pipeline from the Canadian Arctic is probably going to break ground in the next two to three years and it will be at least four to five years before a natural gas pipeline out of Prudhoe Bay breaks ground, I believe the construction of both pipelines will not prevent natural gas prices from rising far above today’s levels. By the end of this decade, the North American natural gas market will be experiencing natural gas prices well over $20US per thousand cubic feet (mcf) due to increased demand and falling supply.

A large part of the increase in demand will come from  Canada’s tar sands industry. A May 2004 study by Canada’s National Energy Board (NEB) entitled “Canada’s Oil Sands: Opportunities and Challenges to 2015” came to the following conclusion about the use of natural gas in Alberta’s tar sands operations:

“Currently, the oil sands industry uses about 0.6 Bcf/d of purchased gas, or about four percent of Western Canadian Sedimentary Basin (WCSB) production. By 2015, this increases to approximately 10 percent, assuming gas production stays level at 16.5 Bcf/d. Current distribution data indicates that about 9.0 Bcf/d is exported to the U.S., with 3.5 Bcf/d delivered to eastern Canada and 4.0 Bcf/d consumed in western Canada. If deliveries to the U.S. and eastern Canada are maintained at 2003 levels, oil sands related demand could account for nearly 50 percent or more of western Canadian available supply.”

While the  NEB predicts that WCSB natural gas production will remain flat until 2015 through significant increases in coal bed methane (CBM) production compensating for declining conventional production, I believe this prediction is overly optimistic. With Canada producing very limited amounts of natural gas from CBM wells (less than 1% of total production), I find it highly unlikely that Western Canada will be able to keep production flat over the next several years before a Canadian Arctic pipeline comes online.

Another reason the Canadian and Alaskan Arctic pipelines will not prevent a huge natural gas crisis is that neither pipeline system is likely to get built on time or on budget. Both of these projects are some of these largest construction projects ever undertaken in North America.

The 800-mile Trans-Alaska Alaska pipeline that currently delivers crude oil from Prudhoe Bay to Valdez, Alaska provides some insight into the challenges of building a large pipeline system. According to Alaska Business Monthly, the Trans-Alaska Pipeline System’s original cost estimate was only $800US million. The pipeline’s final cost was $8US billion. While much of the increased cost could be attributed to delays and lack of personnel experienced in building pipeline systems in arctic conditions, not all of the blame for the massive cost overrun can be attributed to timing and inexperience. Rising commodity prices of the era, including steel and diesel fuel among other items, contributed greatly to the cost of the pipeline. Given today’s rising commodity price environment, it is safe to assume that the cost of building a major natural gas pipeline will increase substantially in coming years.

Politics is also sure to play a large role in the final cost of any arctic pipeline system. With the massive dollar figures associated with any natural gas pipeline system and the many political forces involved in such a large and important project, I believe any estimate made today about a pipeline’s total cost would be far below the cost of the finished project.

With the likelihood of a Canadian Arctic pipeline not coming online before 2010 at the earliest and an Alaskan Arctic pipeline having very little chance of completion before 2013, it is becoming clear that Arctic natural gas will not prevent North America from suffering through a significant and extended natural gas crisis. While such a crisis will be devastating for much of the North American economy, shares of natural gas producers should enjoy a period of extended out performance. Astute investors should recognize this fact and adjust their portfolios accordingly.

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

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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.