Gas prices poised to fall through $2/MMbtu floor-but recovery's around the corner

Dec. 7, 2001
US natural gas prices are poised to fall below $2/MMbtu, but slumping production and increasing demand in the first quarter will mean a price recovery.

The first withdrawal of natural gas from storage occurred this week. Will it have come in time to rescue gas prices from the cellar before the end of the year?

To paraphrase a less-than-illustrious politician of recent vintage, that depends on what your definition of "cellar" is.

Considering that US natural gas spot prices have plunged to an average $2.25/MMbtu this month, down almost 80¢ from a month ago and not much more than a third of where they were a year ago, it certainly feels like the first few steps into the basement.

If, as expected, warmer-than-normal prevails across much of the US in the coming days, spot gas prices are likely to slip through the $2.00/MMbtu floor that is such an important psychological watershed for idling rigs.

But market fundamentals are already beginning to set the stage for an upward correction. The extent of that rebound will largely be dictated by the kind of weather seen across North America this winter. In the long run, however, industry fundamentals still support upward pressure on prices more than they do downward pressure.

First withdrawal

The American Gas Association this week reported a withdrawal of 16 bcf from storage, a bit larger than was expected, for the week ended Nov. 30.

But New York Mercantile Exchange gas futures prices scarecely blinked, even slipping a few cents on the day the AGA storage report was released. It's evident that continued mild weather, the lingering storage surplus overhang, and a comparison with strong withdrawal rates a year ago at this time are putting downward pressure on gas futures prices.

Since the beginning of the heating season Nov. 1, the US has seen temperatures 26% lower than normal and 32% lower than the same time a year ago. Consequently, lagging seasonal demand has prompted unusually late injections into storage, record stock levels at 3.128 tcf, and a jump in the year-to-year storage surplus to 699 bcf. Working gas in storage now stands at 95% compared with less than 74% a year ago at this time.

Canada's situation offers little relief, with the storage picture there comparable. The Canadian Gas Association reported a boost in gas inventories of for the week ended Nov. 23 of 3.9 bcf to a total of almost 471 bcf, another indicator of the lateness of the injection season even north of the border. Canadian gas stocks are running 34.5 bcf above year-ago levels, reaching almost 83% of capacity compared with 76.5% a year ago.

Growing surplus

Given the latest data on storage and a forecast of warmer-than-normal weather across the eastern half of the US during the next week or so, the year-on-year storage surplus is likely to grow.

Ron Barone, in a UBS Warburg research note, estimates another increase in the year-to-year storage surplus next week-as much as 100 bcf.

"Thereafter, the industry could easily face a 1 tcf surplus heading into January, given that the following three [year-ago] withdrawal comparisons are 158, 175, and 209 bcf," he said. "Depending on 1Q02 temperatures, this storage overhang could place tremendous pressure on the spot market in the early part of the year, making deliverability issues virtually irrelevant until the second half of the year.

Barone sees little respite in the near term for North American gas markets, given the persistently strong drilling activity. The count of US active rigs drilling for natural gas fell sharply the week ended Nov. 30-by 29 units to 785-but it still remains well above last year's count at this time: 954 vs. 708. Canadian drilling activity also remains strong, rising 13 units to 309 for the week ended Dec. 4.

Production outlook

Still, there are signs of impending US natural gas production slippage that promises to support a market turnaround in 2002.

An analysis of third quarter US gas production by Houston-based analysts Simmons & Co. points to a downturn in output in the year to come and beyond. Simmons estimated US gas production fell by 1.7% in the third quarter, with year-to-year levels for the period flat vs. 2000. Even taking the year as a whole, with the dramatic surge in drilling that started in earnest with last winter's price spikes, US gas production through the third quarter was a paltry 0.8% above the same period a year ago.

The lack of strong growth in gas production in response to a year of the strongest free-market gas prices ever points to the type of gas wells being drilled in response to the price spike, according to Simmons: "...We believe as many as 200 of the last 350 rigs added since second quarter 2000 have been dedicated to acceleration projects, i.e., shallower, quick-hit wells designed to capture the opportunity presented by high commodity prices.

"The recent downtick in gas-directed drilling with relatively firm gas prices is confirming evidence that wells were being drilled assuming $4/Mcf-plus."

For now, it would seem that a production spurt born of short-term price opportunism is likely to wither quickly. As the gas rig count continues to slump (and a drop below $2/MMbtu is likely to accelerate that decline), gas production will continue to contract during the fourth quarter and in 2002, Simmons noted.

So assuming a return to normal winter temperatures and with it a rebound in demand in the first quarter, the drop in production will help support a fairly healthy rebound in gas prices next year. In light of those expectations, Raymond James & Associates Inc., a St. Petersburg, Fla., investment banking firm, offers a Henry Hub forecast of an average $3.50/MMbtu for the full year.

Of course, prices approaching $4/MMbtu might warrant another round of price-opportunistic drilling, but coming on the heels of a tough year for producers in which both oil and gas prices sagged, resulting cash flows might not support another drilling activity upturn as strong as the last one.

The kind of response to a gas price spike seen this year illustrates the short-term resilience of US gas production but at the same time underscores the persistent problem of declining individual wellhead deliverability in the US.

Next week's column will examine that issue in greater detail-and further evidence of a silver lining behind today's market cloud.

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