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 (NGL’s). 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 10^th to November 11^th 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*

 *Source: Natural Resources Canada

 Canadian Natural Gas Production 2004*

 *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.

© 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.