Energy
Market Review
by Joseph Dancy,
LSGI Advisors, Inc.
Adjunct
Professor, SMU School of Law
October 9, 2003
During the last few weeks the level of natural gas injections into
storage facilities reported by the Energy Information Administration has
been well above average. Natural gas is stored underground near end-use
markets, then is withdrawn to meet peak heating demands of the
residential and commercial markets during the winter.
During
the months of August and September the lack of demand for natural gas
from electrical generating facilities and for heating has historically
meant an excess of supply and weak natural gas prices. That is true
again this year, but note that the price of natural gas in the futures
market this week was $4.83 a million British thermal units (MMBTU) –
down from earlier in the year as expected – but well above the $3.12
per MMBTU natural gas was selling for one year ago.
Historically we only have another 6-8 weeks of natural gas injections before the heating demand begins to withdraw gas from these facilities. Storage levels sufficient to meet winter demand has been defined by many experts as 3.0 trillion cubic feet (3,000 billion cubic feet (BCF) on the chart below) based on historical rates of withdrawal.
But increased demand for natural gas from new electrical generation facilities – almost all of which are powered by natural gas - and increasing demand from the residential sector for space heating may increase natural gas draws this winter.
Last
winter we set a record for storage withdrawals – around 2.5 trillion
cubic feet – well above historical averages, in fact a record. Because
storage facilities require that some gas remain in place to prevent
water intrusion, and as pressures drop it is more difficult to remove
gas from storage, the effective "empty" level of storage is
somewhere between 0.4 to 0.6 trillion cubic feet.
While we started last winter with near record inventory levels, with record withdrawals to meet demand we approached the "empty" level – and in response natural gas prices spiked. The unanswered question for investors is was last years’ record withdrawal a fluke – or does it reflect the new reality of changing natural gas supply and demand constraints?
* Natural Gas Demand/Supply Issues
Due to Clean Air Act restrictions natural gas is the most economical fuel for electrical generation, much more economically viable than nuclear and coal powered facilities from a capital expenditure standpoint. Operating costs for natural gas generating units are higher than for alternative fuels, but the capital expenditure is so much lower the discounted cash flow models almost always point to natural gas as the preferred fuel of choice.
We have also seen a residential housing boom over the last few years and the increased size of the average house – up by over 30% from what we saw several decades ago – increases heating demands. Domestic demand for natural gas is projected to continue to grow for the foreseeable future due to the environmental qualities of the fuel. Canadian imports of natural gas supply around 13% of U.S. demand, liquefied natural gas around 2% of demand, and the rest is met by domestic and offshore production.
On the supply side the advent of three dimensional ("3D") seismic techniques to locate exploration and developmental wells, and the advances in well treatment, the natural rate of decline of production for domestic natural gas wells has increased substantially. Over the last several decades the production decline rate on new onshore wells increased from around 17% per year to nearly 30% per year – an incredible reduction in productive capacity.
As
a result of these decline rates, and the mature nature of the U.S.
geological basin, natural gas production has been flat – and has even
begun to decline according to studies by Raymond James & Associates.
Many experts project further supply declines of 2-3% per year.
Increased drilling activity the last few years has not reversed the trend, and the firm prices for natural gas has increased drilling activity in the United States.
Increasing domestic demand, decreasing domestic supply, and recent record withdrawals from storage make natural gas a very interesting commodity from an economic standpoint. The fact that much of the demand for natural gas is driven by the weather – for heating in winter and for electrical power for air conditioning in the summer – is the wild card that increases short term risk when investing in the sector.
Over time, we are convinced the trends in supply and demand will lead to higher prices.
* Industry Opinions: RBC Capital Markets’ Survey
A survey of industry executives and investors taken last week and reported in Platt’s Oil News indicated a majority of industry leaders think "the shortage of domestic natural gas is the biggest issue facing the U.S. energy industry." Over 80% of respondents "said ‘the threat of a natural gas shortage within the next five to seven years’ would be ‘as bad as or worse than the oil crisis of the 1970s.’"
"Foreign sources of gas would increasingly supply the US within five years, 92% of respondents said; 54% said the US would become as dependent on foreign gas as it is on foreign oil" Platt’s noted. "On average, the respondents predicted that US gas would hit $5.03/Mcf at end-2003, $5.16/Mcf at end-2004 and $5.32/Mcf at end-2005." A RBC Capital Markets' analyst noted the respondents were overly conservative in their price estimates a year ago.
*
Crude Oil Markets
Last month OPEC decreased their production rate to address concerns they had with regard to worldwide supplies. While production may exceed demand from their figures, in the U.S. petroleum inventories remain very low compared to historical levels (green triangle on the graph).
Crude oil production declines in Venezuela – a major exporter to the U.S. – continue, and Nigeria also experienced interruptions. Iraq production is well short of pre-war levels and resumption of exports will require massive capital expenditures.
Exports from parts of the former Soviet Union have added to supplies, but not enough to offset the declines according to some experts. Meanwhile imports of crude oil to China continue to soar with their economy, and China is expected to become the second largest importer of crude oil (after the U.S.) in 2004.
Because crude oil can for some applications be substituted for natural gas, the fact that the price of crude oil has remained relatively firm means that demand switching from natural gas to crude oil based fuels will not have a significant impact on demand at current prices.
© 2003 Joseph Dancy
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