Natural Gas Spikes Keep Market Guessing

Mark Davidson, Editorial Director, Platts North American Natural Gas

Mild weather in 2006 allowed refill of gas storage and pushed North American natural gas prices down from the historic highs hit after 2005's hurricanes. But analysts say increased supply is being quickly mopped up, and near-term price trends will be upward, not down. Increased LNG capability means domestic U.S. demand is competing directly with demand globally, and consumers should be prepared for continued high costs, even this winter.

TWO WEEKS BEFORE LAST CHRISTMAS, WITH the market still reeling from hurricane-driven supply cuts in the Gulf of Mexico, natural gas futures prices rocketed past $14/mmBtu—shattering all previous records and creating anxiety among traders, analysts and consumers that at times bordered on panic.

What a difference a year makes.

After their most lofty and volatile period ever, North American gas prices staged an extraordinary reversal in 2006, brought on by a confluence of bearish forces that nobody predicted.

The mildest January on record was followed by a cool spring and a moderate summer, smothering gas demand. Storage facilities filled at a breakneck pace, with inventories soaring to an all-time high a month before the end of the traditional refill season. Forecasts for another active hurricane season did not prove true, crude oil prices plummeted and, by some estimates, domestic gas production rose for the first time in years—dumping even more gas into an already well-supplied market.

As a result, prices embarked on a year-long decline—interrupted only by a brief, heat wave-related spike in late July—that knocked the NYMEX gas contract to three-year lows by early autumn and pummeled cash prices in the Rockies, which sank below $2/mmBtu for the first time since 2001.

Whether the bear market carries into next year is what market players are trying to guess, but a host of indicators show that to be a highly unlikely scenario. Analysts and industry officials say the perfect storm that rained down on the market last year almost certainly will not recur, meaning the supply/demand balance should quickly tighten up again.

"It's hard for me to understand how prices will stay below $5/mmBtu," said Devon Energy Corp. CEO Larry Nichols. "Marginal drillers will stop drilling. That will not take long at all on a downward price signal. The long-term economics say there has to be upward pressure on gas."

Navigant Consulting Inc., which tracks gas market trends, agreed, saying prices "may have overreacted" to the events of 2006 and that "more upside than downside exists in the market." Energy and Environmental Analysis Inc. predicted prices in 2007 will surpass those in 2006 by a good 10% because "the overall natural gas supply/demand balance remains very tight."

Not all industry observers jumped on the bullish bandwagon, however. Barclays Capital's George Hopley said the mild winter injected a bearish sentiment into the market that held sway all year and will "take more than just the winter to turn around…The market is trying to rebalance itself and it'll probably take more than one season to do it."

'The Natural Gas Crisis Hasn't Gone Anywhere'

In its Winter Fuels Outlook released in mid-October, the U.S. Energy Information Administration (EIA) said record levels of gas in storage and a quiet hurricane season should translate into 14% lower gas prices for utility customers during the heating season that runs through March 31.

But end-users and local distribution companies, which have been burned by such projections in the past, are anything but optimistic.

"While U.S. households using natural gas are expected to get a modest break on their winter heating bills relative to last year, this is cold comfort when costs are nearly double those of just five years ago," the American Chemistry Council (ACC) said in response to EIA's forecast. "Make no mistake, the natural gas crisis hasn't gone anywhere."

"We are not sure if the recent gas decline is temporary or if this is a trend that is likely to continue," said Harriet Wegmeyer of The Fertilizer Institute, whose members, like ACC's, rely heavily on gas as a feedstock. "We are hesitant to express overwhelming optimism."

Numerous utilities announced rate cuts to account for falling wholesale gas prices, but trade groups warned that those actions shouldn't be viewed as a trend.

"A number of systems, municipals and investor-owned utilities have initiated hedge plans to combat price volatility and, as a result of those plans, they entered into contracts based on prices that were posted several months ago," said David Schryver, executive vice president of the American Public Gas Association (APGA), which represents municipals. As of early autumn, "the hedges for winter are yielding a price above the current NYMEX winter price."

Daphne Magnuson, a spokeswoman for the American Gas Association (AGA), offered a similar prognosis. "If the weather is colder and customers do use more gas, even if it costs less per therm, they could pay as much as what they paid last year," she said. Despite the drop in wholesale prices, heating bills "will still be in the neighborhood of the highest prices that people have paid in our lifetime."

Supply vs. Demand

In early October, as wellhead prices sank to three-year lows, Chesapeake Energy stunned the industry by announcing that it would shut in 100,000 million cubic feet per day of unhedged gas production—6% of its total output—until prices rebounded.

A week later, Questar Exploration & Production followed Chesapeake's lead by curtailing 32,000 Mcf/day of its unhedged Rocky Mountain gas for the same reason.

The unusual moves prompted some observers to speculate that even more gas would come off the market this fall and winter, belying government and industry projections of domestic production growth.

"There has been a fairly dramatic change in the outlook for natural gas and oil just over the last few weeks," said John Gerdes, head of The Gerdes Group, after the two firms announced the shut-ins. Producers, which typically begin planning their annual budgets shortly after Labor Day, are likely to reassess their initial plans, he said.

"If you give this industry sub-$7.50/mmBtu gas for any sustained period of time, we wouldn't be surprised to see a stalling out in drilling activity," Gerdes said.

The Natural Gas Supply Association (NGSA), which represents large exploration and production companies, said gas output would rise again in 2007, primarily because the industry has restored much of the storm-curtailed gas in the Gulf of Mexico and has stepped up drilling in unconventional basins.

"Going forward in 2007, the key market drivers point to a continued steady increase in production, reflecting high rig counts and the startup of major new deepwater developments," NGSA said. Natural gas production in the continental U.S. has been "moderately increasing, mostly the result of onshore expansions in the Rockies and Texas."

Another major contributor to U.S. supplies will be liquefied natural gas (LNG), though experts disagree on just how much of that commodity will make its way to U.S. shores—and at what price.

While most new LNG import capacity, in the form of new projects and expansions, isn't expected to come on stream before 2008, the EIA said LNG receipts nonetheless are expected to total 920 billion cubic feet in 2007—up 41% from this year—as existing terminals see more of their capacity snapped up.

But while most analysts expect the U.S. to bring in between 10 Bcf/day and 15 Bcf/day of LNG by 2030, one Houston-based banker believes actual volumes could fall well short of that target because of higher prices abroad.

Clay Jones of Société Générale said that EIA's "worst-case" scenario of 5 Bcf/day by 2030 may have some merit. He said competition from foreign markets will likely cut into shipments bound for the U.S.—no matter how many domestic import terminals are built. "If a supplier can get a better price in Europe and Asia and has the ability to divert, then supplies will go to the highest-paying market," he said.

That observation proved prescient just a couple of weeks later, when Russia's Gazprom Oao startled the U.S. gas industry by saying it would develop its giant Shtokman gas field alone—and ship gas from Shtokman to Europe via pipelines rather than liquefy it for export to North America as originally planned.

"If you take Shtokman out of the equation, 6 Bcf/day is a heck of a lot of LNG to lose," one analyst said. "You're taking out 20% to 25% of the potential Atlantic Basin supply. That's a big chunk."

On the demand side of the equation, NGSA conceded that increased gas supplies will be matched, to some degree, by higher consumption this winter. The producer trade group said total gas usage is expected to rise by 5.4%, or 600 Bcf, over the 2005 to 2006 heating season.

Assuming normal weather, EIA pegged average first-quarter gas demand at 78.5 Bcf/d in 2007 and 80.7 Bcf/d in 2008, "or about 10% greater than the average in the first quarter of 2006."

Separately, EIA projected that gas consumption will rebound in 2007 by about 2.9% nationwide, fueled by industrial demand rebounding after 2005's hurricanes.

More Regulation Eyed for '07

The spectacular collapse of the Amaranth Advisors and MotherRock hedge funds, which lost billions of dollars speculating in the gas futures market during the summer and fall, has some industry trade groups saying greater federal oversight of over-the-counter (OTC) gas market is needed. OTC physical gas prices serve as settlement bases for some derivatives.

"The government is currently handicapped in its ability to deter market misconduct," said Bert Kalisch, president and CEO of APGA, the municipal utility trade group. "The excessive volatility created by the activities and subsequent fallout of these hedge funds further supports the need for greater transparency in natural gas trading."

Kalisch's remarks came in a letter supporting a pending Senate proposal to give the Commodity Futures Trading Commission authority to collect data from traders holding large OTC derivatives positions.

Industry and end-user groups butted heads at a mid-October Federal Energy Regulatory Commission (FERC) technical conference to consider whether reforms are needed in the way physical gas trading data is reported.

AGA urged FERC to mandate fixed-price reporting to index publishers such as Platts. "Voluntary reporting—while it certainty has been helpful—does not appear to go far enough in ensuring greater market confidence today," an AGA official said.

But NGSA, among others, balked. "Mandatory price reporting could have unintended consequences, such as chilling the willingness of buyers and sellers to do fixed-price deals, which serve as the foundation for more widespread basis transactions," the producer group said.

Alex Strawn, chairman of Process Gas Consumers Group, agreed. "Reporting has been increasing. If you make it mandatory, you reverse that trend," he told FERC. "We feel like the market is becoming more resilient. We don't want to do anything to hurt that."

Around the Globe…

A dispute over natural gas prices prompted Russia to cut natural gas exports to Ukraine on January 1, creating international headlines, rattling nearly every European country and raising a host of new concerns about energy supply security across the region. Gas shipments were restored three days later, but a preliminary long-range supply agreement between the two nations wasn't reached until September—and fears of a repeat this winter still linger.

In a stunning reversal, Russia's Gazprom Oao in October said it would develop its giant Shtokman field alone and ship gas from the field to Europe via pipelines rather than liquefy it for export to North America. Under consideration for partnership in the development were Norway's Norsk Hydro ASA and Statoil ASA, the U.S.'s ConocoPhillips and Chevron Corp., and France's Total. But Gazprom CEO Alexei Miller said those firms "failed to offer assets which would be comparable by their capacity and quality to Shtokman field reserves."

The liberalization of the European gas markets is expected to continue in 2007 under the European Union's Gas Directive, which established deadlines for opening up individual national markets to competition and increasing the cross-border connection of gas transportation systems. In Great Britain, which has led the way on deregulation in the region, full competition at the residential level is expected by July 1. And the trend is stretching beyond Europe. Although full deregulation for gas consumers in India and China is a long way off, both countries have signaled their intentions to move to market pricing as soon as possible.

Eloise Logan, London