Spiking gas prices hit homeowners hard, and industrial users harder

Mark Davidson

With no easing of the supply/demand imbalance in sight, 2006 is almost certain to be a year of higher prices and increased market volatility.

IN NOVEMBER 2004, RENOWNED ENERGY analyst Daniel Yergin warned that the U.S. was facing a period of "significantly increased risk of higher and more-volatile natural gas prices."

Yergin, chairman of Cambridge Energy Research Associates, told a Joint Economic Committee of Congress that if industry, government, and consumers don't find ways to ease the ever-tightening supply/demand gap, "an event as simple as an abnormally hot summer or cold winter could push gas prices well above recent levels, to the $6.50 to $8/mmBtu range in the summer, and above $10/mmBtu during a particularly cold winter."

Some of Yergin's peers, along with several gas industry officials, called those predictions alarmist, insisting that market dynamics would help balance out supply and demand and avert price spikes. But within a year, virtually all of Yergin's predictions had come true, and 2005 became, without question, the most volatile year ever for the North American natural gas market.

The turmoil was driven by a string of bullish forces, many of which could not be foreseen. Early in the year, reports of more year-over-year domestic production declines prompted renewed concerns about potential supply shortages and sent NYMEX gas futures prices to new highs. One of the hottest summers on record then sparked a surge in gas demand by power plants, resulting in a gradual erosion of what had been a hefty surplus of gas storage inventories.

By mid-summer, crude oil prices had soared past $60/barrel due largely to global political and economic forces and—in predictable fashion—brought U.S. natural gas prices along for the ride. And with cash and futures prices already topping $9/mmBtu—nearly double where they were just a year earlier—the unthinkable happened: Back-to-back hurricanes slammed into the Gulf of Mexico in late August and early September, knocking out substantial volumes of much-needed production and isolating processing plants and offshore pipelines. Most of that gas was still shut in weeks after the storms made landfall.

While public and media attention was focused on gasoline prices that surpassed $3/gallon for the first time ever, natural gas prices shot into uncharted territory, topping $14/mmBtu and sending the industry into a panic. As utility and local officials issued repeated warnings of sky-high winter heating bills, industry executives and federal government officials renewed their calls to immediately open restricted gas reserves to drilling.

The Natural Gas Supply Association cautioned in late September that supply disruptions stemming from Hurricanes Katrina and Rita would almost certainly strain an already tenuous supply/demand balance, "likely resulting in higher wholesale costs" during the winter of 2005–2006. And the DOE's Energy Information Administration, painting a turbulent picture of the post-hurricane market, made sharp upward revisions to its price prognoses. It added nearly 35% (or $3/mmBtu) to its fourth-quarter estimate, 16% ($1.19/mmBtu) to its full-year 2005 forecast, and 15% ($1.08/mmBtu) to its 2006 projection.

Feeling the pinch

The natural gas price spikes and volatility were not bad news to everyone. For many exploration and production companies, the lofty value of their output and reserves prices meant record profits, increased capital expenditures, and more aggressive drilling programs in both conventional and frontier plays. For the merchant sector, whose recovery from the post-Enron collapse was well under way, the volatility helped attract new players and enhance liquidity.

But for consumers—and particularly for industrial end users that rely heavily on gas for feedstock—the news has been nothing but bad. Many fertilizer and chemical companies have curtailed operations, shuttered plants, and/or moved operations overseas. Nearly all have seen their profits suffer. And as each day passes with gas at unaffordable levels, those companies' outlooks for the future have become increasingly bleak.

"We are seeing large users like chemicals, steel, glass, plastics, and paper that have shut down, marginalized by the high cost of natural gas," Paul Cicio, executive director of the Industrial Energy Consumers of America, said in early October. "We don't see those plants coming back." With gas prices expected to top $10 at least through early 2006, executives of gas-intensive manufacturing companies now believe the U.S. "is not a place where you want to invest your capital when you can invest the same capital elsewhere and cut your energy costs by more than half," Cicio said.

The American Chemistry Council (ACC) echoed those sentiments. "We are very concerned that we and other manufacturers have passed the point at which high natural gas prices can simply be absorbed," the ACC said. "Prices have been so high for so long that we now face a stark choice between maintaining U.S. operations and moving our operations, jobs, and other economic benefits to nations where natural gas is more affordable."

Meanwhile, in nearly every region of the U.S., local distribution companies have been raising their gas rates—in many cases to record levels—as a result of an already tenuous supply/demand balance exacerbated by the hurricanes' impact on supply. And the DOE in mid-October warned of a "particularly difficult winter" for gas consumers, saying that residential users, on average, will spend about $350 per month to heat their homes—a 48% jump from the previous winter.

Is help on the way?

With gas prices at historic highs and demand on the rise, many industry, government, and consumer groups are pinning their hopes on an expected surge in liquefied natural gas (LNG) imports to help put supply and demand back into balance.

In fact, the pace of LNG terminal proposals ramped up in 2005 as new players, eager to capitalize on record-high gas prices, jumped into the fray. As of late October, more than 40 projects were on the table, although most officials and analysts agree that only a fraction will ultimately be built.

The pace of project approvals escalated as well, with regulators stressing the need for quick action. In addition to the five existing terminals in the U.S., the Federal Energy Regulatory Commission (FERC) has issued permits for seven more—most of them along the Gulf Coast. Several more are awaiting FERC approval. Meanwhile, Canadian officials have signed off on several terminals in the eastern part of that country.

The number of terminals receiving regulatory approval in North America "would have been a surprise a couple of years ago," said Chris Ellsworth, manager of the natural gas practice for Science Applications International Corp. But with no signs that the current supply crunch can be alleviated with domestic production alone, he said it's likely that FERC and the Canadian government "didn't want to be perceived as a roadblock."

According to a report by Wachovia Securities, the U.S. gas industry will become inextricably linked to the global energy market as imports of LNG soar over the next decade. It said domestic LNG regasification capacity, which currently stands at about 2 billion cubic feet per day, "should easily grow to 10 bcf/day and likely more as existing terminals are expanded and new ones already under construction are completed later this decade." In a separate study, the Center for LNG noted that liquefied gas currently accounts for roughly 2.5% of U.S. supplies but said that that could grow to about 8% by 2010.

Still, it has not been smooth sailing for sponsors of LNG projects, particularly in the Northeast. Public and political opposition stemming largely from safety and security concerns has derailed several proposed terminals from Maine to Rhode Island, and new anti-LNG coalitions continue to pop up. Meanwhile, analysts say it's becoming increasingly evident that the U.S. will have to compete for limited LNG supplies on a worldwide basis—particularly with Spain, the UK, and the Asia-Pacific region.

Determined not to put all of their eggs in the LNG basket, industry and government officials are looking for solutions closer to home. For instance, after years of false starts, Congress finally passed a comprehensive energy bill over the summer that provides financial incentives for boosting gas production, gives FERC more direct authority over key gas infrastructure (including onshore LNG terminals), orders up an inventory of offshore gas reserves on the Outer Continental Shelf, and streamlines the permitting process for onshore and offshore drilling.

Meanwhile, 2005 has been particularly active for a pipeline industry determined to eliminate bottlenecks—especially in the Rocky Mountain West—and move gas to markets that need it most. Among the largest proposals unveiled during the year: Kinder Morgan Energy Partners and Sempra Pipelines & Storage's 2 bcf/day mega-pipeline from Wyoming to Ohio; El Paso's 1,000-mile Continental Connector designed to carry 1 to 2 bcf/day from the Rockies to the eastern U.S.; and EnCana Oil and Gas' Entrega Pipeline, a 328-mile, 1.5 bcf/day system in Colorado and Wyoming.

"Voluntary price reporting is working"

The merchant energy sector continues to attract a new crop of players eager to take advantage of increased volatility in the gas market—particularly investment banks that bring deep pockets along with their expertise.

That paradigm shift was evident in the newsletter Gas Daily's marketer rankings for the second quarter of 2005, in which firms such as UBS and Merrill Lynch replaced marketing giants such as Enron, Mirant, and AEP. "It's a continuing trend since the industry hit its low point," noted analyst Ben Schlesinger, president of the consultancy Benjamin Schlesinger & Associates. "It's all part of the recovery—an infusion of talent and creditworthiness."

In September alone, Calpine announced a new trading venture with Bear Stearns, and Cantor Fitzgerald said it would expand its brokerage business to include an energy services division. And "there's more to come; it may even get a little crowded," predicted Peter Fusaro, head of the consultancy Global Change Associates. "The market has been rebuilt—we got past that hurdle—and we're seeing liquidity up again, so there are a number of investment banks and hedge funds interested now."

The trading sector continues to suffer some residual pain from the merchant sector's meltdown in 2002. The federal government continues to charge companies and individual traders with fraud and gas market manipulation over alleged reporting of bad price data to firms such as Platts, and both civil and criminal cases are still pending. But in a victory for the publishers, a proposal to shift from a voluntary to a mandatory price reporting system was dropped from the energy bill, though the legislation does bolster federal authority to monitor markets and, if necessary, tighten price transparency rules.

"By and large, voluntary price reporting is working," FERC Chairman Joseph Kelliher proclaimed after the energy bill was signed into law on August 8. "I don't see a need to go beyond that and mandate price reporting."