Warm winter to date masking another looming gas supply crunch

Could the warmest winter in memory simply be temporarily masking another natural gas supply crunch on the horizon?

That question begs a follow-up: Will the upshot be a sharp turnaround in natural gas prices later this year?

Some analysts think that the recent collapse in gas prices is setting the stage for a steep decline in US gas production, which in turn will result in supply lagging just as economic recovery revives demand. Hence the price spike.

Raymond James & Associates Inc. estimates that Henry Hub gas prices will jump to $4.25/MMbtu by the fourth quarter from an average $2.30/Mmbtu in the first quarter. For the full year, RJA anticipates Henry Hub gas prices will average $3.25/MMbtu. Its forecast also calls for gas prices averaging $2.80/MMbtu in the second quarter and $3.65/MMbtu in the third quarter.

The St. Petersburg, Fla.-based investment banker's chief analyst Marshall Adkins notes that his contrarian price forecast for all of 2002 is actually a reduction of 25¢/MMbtu from its previous forecast, in recognition of the unusually warm weather that has prevailed this winter, at least up until about a week ago. Adkins cites data from the National Weather Service that suggests that this winter is on track to break the record, set only 2 years ago, for the warmest winter in history.

However, RJA bumped up its fourth quarter price forecast by 25¢/MMbtu, reflecting the steepness of the recovery later in the year relative to the weather-related price slump early in the year.

And the turnaround is purely a matter of supply collapsing with the rig count.

"We remain convinced that US natural gas supply is falling much faster than any [Wall Street] estimates than we've seen and falling much faster than any time that we've seen in the past," Adkins says in a recent research note. "Specifically, we believe that US natural gas production this summer will be down more than 5% (or 2.5 bcfd on a year-over-year basis)."

The logic behind this assumption rests on the combination of a sharply deteriorating rig count and unusually high gas well decline rates converging "to create a supply reduction that the gas markets have never seen."

Adkins sees early signs of this looming supply crunch in the production companies are reporting for the fourth quarter. Looking at this early data suggests that fourth quarter US gas production is down by 1.7% from the third quarter of last year and down almost 3% from the same period the year before. Taking an anomalous situation with ExxonMobil Corp. out of the picture, and the quarter-to-quarter decline is 2.7%.

Numbers gathered by Lehman Bros. analyst Thomas Driscoll tell a similar story. Overall, he expects US marketed gas production to decline 1.5-2.5% in 2002. What's interesting is that, for all the frenzied gas drilling 2001, marketed production rose by a mere 0.29% among the companies Lehman Bros. surveyed. That followed 2 consecutive years of declines, 2.35% and 1.06%, in 1999 and 2000, respectively.

Filling the gap

Will imports fill the gap on US gas supply and render RJA's forecast moot?

That's not likely to happen with Canadian gas. With the start-up of the Alliance pipeline in mid-2001 and a production spike owing to a strong 2000-01 drilling surge in Canada, Canadian gas supply did jump early last year, Adkins notes.

However, Canadian supply into the US has fallen by 500 MMcfd over the past 6 months. Even new increments of production coming from major new developments, such as Ladyfern, overall Canadian drilling this winter is down sharply from a year ago.

And LNG import terminal expansions are not far enough along to make much of a dent in the coming supply crunch.

Demand rebound

Anticipating the looming shortfall in supply begs the question of when gas demand will rebound.

Adjusting for the weather-related demand, there has already been a sharp increase in US gas demand vs. a year ago, Adkins contends. But that also reflects a demand response to $6-9/MMbtu gas prices.

Now with gas prices hovering near—and sometimes below—$2/MMbtu, there is certain to be a flurry of fuel switching back to gas. That factor alone will account for an increment of 2-3 bcfd going through the summer, Adkins estimates.

If the economy continues to recover, as is widely expected, gas demand will up considerably more than 2-3 bcfd increment.

Basically, Adkins sees 2002 gas prices to be a repeat of 2000: the year starts out with gas prices hovering near $2.00-3.00/MMbtu, ramping up steadily but meaningfully "as low summer gas prices and low summer gas injections prove to the market that supply and demand [are] indeed very tight."

As with 2000, then, the stage will be set for a shortfall in the gas supply-demand balance by next winter.

So the remaining question is one of timing as determined by the level of weather-related demand this winter. If sustained cold weather keeps the end-of-season storage level at over 1.5 tcf, then Adkins predicts the gas price recovery will come later in the summer. If it is less than 1.5 tcf, then gas prices are likely to move up early in the summer.

Whether that fuels yet another rollercoaster cycle through 2003 probably hinges on the strength of any economic recovery.

OGJ Hotline Market Pulse
Latest Prices as of Feb. 8, 2002