Gas market bears come out of hibernation

It is appropriate that the end of the winter heating season has brought the natural gas market bears out of hibernation.

In the market's rush to anoint this as another Year of Gas—and likely to be followed by more of the same—it seems to have overlooked the contrarians this year.

Contrarian is decidedly the right term to apply to Lehman Bros. analyst Thomas Driscoll. While other analysts are expecting natural gas prices to settle in at a level closer to $6/MMBTU than to $5.00/MMBTU, Driscoll has sharply ratcheted back his gas price forecast for the year, to $5.00/MMBTU from a previous prediction of $5.75/MMBTU.

He contends that steep declines in underlying natural gas demand have been masked by the extremely cold weather and resulting heating demand spike earlier in the winter just past.

Driscoll thinks this weakening of structural demand will better manifest itself over the next 2 months. Much of the focus by gas markets in recent months has been the gaping deficit in storage vs. expected demand levels. The estimates of the year-to-year storage deficit at the end of the heating season have, in recent months, been projected at levels readily encompassing record lows. Even more-conservative forecasts after the first of the year still put the year-to-year storage deficit as high as 600 bcf. But Driscoll reckons the year-to-year deficit, currently put at 360 bcf, could even disappear altogether in the next 2 months.

As storage levels rebound, then watch for natural gas prices to fall sharply—to as low as $3.50-4.00/MMbtu, Driscoll believes. He is not persuaded by all the bullish forecasts of rising natural gas consumption for power generation demand that gas demand growth will be robust enough to sustain currently high prices this year.

Gas demand decline

US natural gas demand for uses other than space heating remains a "troubling" 8 bcfd below year-ago levels, Driscoll estimates. This corresponds to 13% of average annualized demand estimated for the US.

Gas demand has scarcely risen in recent weeks, despite a fairly sharp falloff from the stratospheric prices seen last December.

The reason for the decline in demand is the incentive that higher prices in 2000 gave consumers to conserve, switch to other fuels, or curtail operations. Driscoll estimates that this price-induced slump in nonheating demand rose from a low of 2-3 bcfd during the fourth quarter of last year to a high of 8-10 bcfd in late December.

"When natural gas prices fell sharply in mid-January, we expected natural gas demand to recover quickly—but we now believe that we have regained only a small share of the demand lost in late December and early January," Driscoll said.

Storage status

With demand down, natural gas injection is certain to be stepped up, according to this scenario. Driscoll contends that injection levels could exceed those of a year ago by 6-9 bcfd in April and May.

This is situation is like looking at a negative of the market a year ago, he observes.

"The winter of 1999-2000 was among the warmest on record, yet storage withdrawal rates were normal. Normal withdrawal rates, despite extraordinarily low winter heating demand a year ago, implied that the market was extremely tight.

"However, market prices for natural gas failed to reflect this tightness until the feeble natural gas storage refill rates of last April and May made it clear to all that the market was much tighter than it had been in previous years."

That situation yielded a rise in natural gas prices that traveled from $2.50/MMBTU in first quarter 2000 to $3.00/MMBTU in April-May and $4.25-4.50/MMBTU in June-July. So the stage was set for an even sharper spike in price when heating demand jumped, on the back of a string of record cold waves sweeping the US last year. The difference in heating demand for natural this past winter vs. the previous one is about 923 bcf, Driscoll estimates.

"However, the industry has met that demand without increased storage withdrawals [and without increased supplies, in our opinion], as other gas users have reduced their consumption," he said.

Continued demand patterns

As the year-to-year storage deficit fades and as recent demand patterns continue, gas inventories are likely to start the next heating season at close to the traditional level deemed appropriate, 3 tcf. But storage is not likely to exceed this level by much, Driscoll notes, as gas demand is likely to recover in a climate of reduced prices.

But what about the scramble to develop more gas pipeline capacity to meet soaring electricity demand, especially in California and the rest of the US West—and in the next likely area of concern, the US Northeast? Driscoll is not convinced there will be enough incremental power demand for gas to keep a prop under prices.

"Although hot summer days could undoubtedly lead to localized natural gas price spikes, we do not expect sustained high prices this summer as a result of power demand increases," he said. "We speculate that increased natural gas consumption to generate power this summer will add no more than 2-4 bcfd to gas demand [and perhaps much less, depending on the weather and the state of the economy]; this is far less than the 8-10 bcfd of demand that appears to be missing currently."

Power expectations

In the past 6 years, gas consumed by power generators—including nonutility generators—has risen about 750 MMcfd/year. During this time, natural gas fed about 28% of all incremental power demand.

"Had natural gas provided all of the incremental electric demand growth, we estimate that the incremental gas load for power generation would have been 2.5 bcfd," Driscoll said. "This was a period during which [gross domestic product] growth exceeded 4%. Even a bullish scenario for gas consumption would likely reflect slowing GDP growth and thus slowing electric consumption growth."

Offsetting this scenario to some degree is the continuing collapse of hydropower supply in the US West this spring and summer, which could add another 1 bcfd to gas demand for 6 months.

Still, it won't be enough to offset the plunge in nonheating demand for gas stemming from high prices and a slumping economy, according to Driscoll.

The analyst slips in a qualifier, however, that may well prove to be a bigger problem for his bearish forecast than he acknowledes now: such a forecast assumes the absence of major spikes in oil prices.

As readers of this space last week are aware, OPEC's hard line on supporting an oil price of $25/bbl for its marker basket of crudes may well set the stage for a repeat of last year's oil price spikes of well over $30/bbl. That is likely to occur in the second half, as oil demand rises seasonally.

One of the contributing factors in the slump in gas demand this past winter was, as Driscoll points out, a certain level of fuel-switching in response to high gas prices. It should be noted here that oil prices started coming off their highs as early as late October last year and were settling back to $25-27/bbl by the time gas prices were peaking at more than $10/MMBTU in December.

So as oil prices climb back to $30/bbl again and as gas prices slip below $4.00/MMBTU again, isn't likely to assume that the recent round of fuel switching to oil from gas may reverse itself again? And wouldn't that spur gas demand and prices higher again?

This could happen with further OPEC output cuts that could spawn severe oil market tightness by the fourth quarter this year.

The betting here is that a spike will happen even sooner, when Iraq starts making trouble this spring over US review of and possible changes in the sanctions regime. If all 2 million b/d-plus of Iraqi exports comes off the market again, look for that $30 sooner rather than later. And then let's see where gas prices go.

OGJ Hotline Market Pulse
Latest Prices as of Apr. 6, 2001

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