Natural gas prices volatile but still on upward track

Natural gas prices are mimicking oil prices as the heating season arrives: They're extremely volatile, higher than expected, and likely to rise further as winter approaches.

Despite the decline of about 15

Anticipation of higher demand as cooler-than-normal weather pushed spot prices to almost $3 at the end of last week, coming on the heels of an earlier rise of about 25

But the futures price strip suggests a more-bullish outlook. The November contract expired last week at $3.09/MMbtu, compared with $1.97 in 1998. And the December Nymex contract is at a hefty $3.22/MMbtu; the near-month contract is expected to hover near $3 until March, when it slips only a bit, to $2.85/MMbtu.

This sort of bullish forecast comes against a backdrop of US gas storage levels coming in pretty close to the optimal level for the onset of the winter heating season. Storage hit 2.99 tcf at the end of October, compared with 3.05 tcf the same time a year ago and pretty close to the preceding 5-year average of 2.91 tcf. The latest injection figures show a greatly reduced rate, down to 13 bcf for the week ended Oct. 22 vs. 42 bcf in the prior week, 36 bcf for the same week in 1998, and 29 bcf 2 years ago. On a year-to-year basis, storage levels are at a 55 bcf deficit vs. 32 bcf and 16 bcf in the preceding respective 2 weeks. Unless there is another cold snap soon, that picture isn't likely to change soon.

A key question here is whether an uptick in drilling activity will do anything to skew this perspective. For the first time in more than a year, the US active rig count, as measured by Baker Hughes, is higher than year-ago levels. For the week ended Oct. 22, the tally of US active rigs reached 750, up 29 on the prior week and 34 higher than the same time a year ago. A comparable scenario is evolving in the Canadian drilling sector. Two observations may render this concern moot: For one thing, this drilling upsurge has not happened soon enough to allow a significant increase in available wellhead deliverability yet to make a difference in gas supplies this year. Second, there are a lot of pent-up oil targets that remained undrilled for months as oil prices languished and US operators shifted their drilling budgets (what wasn't cut, anyway) to natural gas vs. oil. Given the even greater likelihood that oil prices will spike later this winter as OPEC continues to do a better job on cohesion than anyone expected (the recent reports of minor slippage in compliance with pledged cuts notwithstanding), it follows logically that operators will focus their drilling budgets more on oil and less on gas in the short term to take advantage of what may ultimately be a short-lived oil price rally.

In fact, the higher oil prices and the ripple effect from them onto products has helped stimulate demand for gas. With resid prices higher, relatively speaking on a btu basis, than natural gas, there has been a noteworthy amount of fuel-switching to natural gas as it continues to gain market share from resid. Some analysts project that natural gas will capture all of the incremental space heating demand this winter-even with gas topping $3/MMbtu.

But the longer-term outlook for weather suggests a less-sanguine perspective, at least as far as the winter heating season is concerned. The Energy Information Administration, beginning with its most-recent short-term energy outlook, has adopted new weather premises that reflect a 3-decade long warming trend identified by the National Oceanographic and Atmospheric Administration. These new assumptions, says EIA, result in substantial seasonal shifts in US energy demand projections as well as a net reduction in projections of annual energy demand. Accepting this assumption of the warming trend lowers EIA's estimate of annual projected energy consumption for October 1999-September 2000 by about 0.3%. The biggest hit in this revisionist forecast is made on projections for January-March, when EIA sees total energy consumption falling by about 1%. Conversely, the only uptick in seasonal energy dmeand comes next summer, as power plants burn more natural gas to meet increased cooling-related electricity demand.

And the change in weather assumptions affects natural gas more than any other fuel, according to EIA. Natural gas constitutes 24% of total fuel supply but accounts for 75% of the adjustment to expected energy demand resulting from the change in weather premises.

What does all this mean? The logical thing to assume here is that natural gas prices will be more sensitive to weather patterns than ever before-meaning greater short-term volatility during the two peak seasons-but, spread out over the year, the hills and valleys for natural gas prices will come to flatten out more, especially as storage efficiencies continue to improve. What's better for planning purposes: $2.25-2.50/Mcf averaged for the whole year, or a range of $1.50-$3.50 for the whole year? Flattening the price curve from season to season will certainly make natural gas a friendlier fuel for the utilities and industries buying strategies, even if the commodities traders have more heart attacks when the mercury spikes.