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Been Down So Long

The US Energy Information Administration reported a 200 billion cubic feet (bcf) drawdown of natural gas supply for the week ended Feb. 1—19 bcf less than the figure for the same period last year but 12 bcf more than forecast by analysts.

Last week, a record 274 bcf was subtracted from US storage, taking inventory below year-ago levels. Canadian storage numbers are at their lowest levels since 2005, before taking into account brutally cold weather afflicting much of the Great White North. And weather forecasts recently released for the US show colder temperatures for February and March through most of the country.

Natural gas prices are showing signs of breaking out of nearly two-year trading range. The question is whether the recent price rise is sustainable.

One of the main drivers has been the harsh winter weather in the US northeast and Midwest and eastern Canada; weather is always the wildcard for winter demand and prices. And US/Canada is often cast as a single, interconnected market. When markets are tight and prices are high in the US, the situation is the same in Canada.

But more important is that it’s been much colder in Europe, which means liquefied natural gas (LNG) tankers that may have been destined for US shores are being diverted to that continent, where they can get as much as USD2 more per thousand cubic feet (mcf). The lack of LNG flowing into North America removes what could be downward pressure on natural gas prices because of increased supply.

LNG was once blamed for natural gas’ plummeting value; it’s now a critical factor in its turnaround.

LNG is transforming what used to be a regional business into a global market. Traditionally natural gas could only be transported via pipeline, but freezing it into a liquid makes it possible to ship overseas by tanker. LNG terminals are springing up all over the world and in Canada, and projects have been proposed on both coasts to link up with the continental pipeline network that serves central Canada and the US.

Last spring, US natural gas prices were far higher than prices in Europe, as measured by the London-traded gas contract. At one point, gas prices in the US were more than double what was available in the European Union. Producers with LNG for sale sent as much as possible to US shores to take advantage of those attractive relative prices. The surge in LNG imports sent US inventories sharply higher and again hit gas prices.

Up until now, LNG has been dumped into the already saturated North American markets. But now it can be more easily stored and transported to places like Asia and Europe. 

Startup delays for LNG projects in Norway, Trinidad, Equatorial Guinea, Nigeria and Indonesia have led to an undersupply situation worldwide. Increasing demand from Spain and Japan in particular is further tightening the market.

There may not be any more additional LNG available for the US market for much of 2008 than was available during 2007. The tight LNG situation will keep LNG cargoes well bid in Europe and Asia. If the North American market wants more LNG, prices will have to rise closer to global levels. 

Another factor to keep an eye on is Canadian drilling activity, which has been extremely weak. Falling gas prices were enough to impact drilling activity on their own. Tax changes at the federal level and royalty adjustments in Alberta exacerbated the problem.

Since 2001, production from Canada’s Western Canada Sedimentary Basin has flattened. The area was drilled aggressively at the outset of the new century, but that activity has tapered during the last couple years. Efforts are increasingly focused on smaller, lower-quality reservoirs. More wells are needed to replace older wells, but production increases come about more slowly.
Companies are already struggling to sustain current production levels; any increases only meet new demand. It’s widely believed that natural gas production in Alberta peaked in 2006; according to ARC Financial, drilling activity is at its lowest in a decade and production is off by 1.5 bcf per day (bcf/d).

At any rate, the active rig count—a measure of how many drilling rigs are operating in a particular market—has cratered. Ultimately, falling activity spells falling production, and falling production means falling exports to the US.

One long-term factor to keep in mind is the shift to natural gas-fired electricity plants in the US, even in the absence of a national energy policy aimed at reducing carbon-dioxide emissions.

Citigroup, JPMorgan Chase & Co and Morgan Stanley expressed discomfort with the idea of financing the construction of new coal-fired power plants because of growing concern over greenhouse gas (GHG) emissions and the potential government response, and momentum for developing clean coal technology has slowed considerably.

If the US government adopts financial measures to address emissions, the economics of coal-fired plants will be compromised. How much a GHG solution will cost is unknown, but electricity consumption is rising by 2 percent every year.

The only realistic baseload electricity solutions left are nuclear—there’s still a lot of public anxiety about nukes, and it takes a long time to get a plant built—and natural gas.  

The natural gas inventory picture from an historical perspective remains mildly bearish, but the headwinds aren’t as strong as in late 2006 and early 2007. The trends in LNG imports, European gas prices and Canadian drilling activity also tend to support inventory moderation and higher prices over the next 12 months.

A number of one-off factors that could send prices soaring, notably an active 2008 Atlantic hurricane season or another vicious cold snap in the Northeast US.

During 2007, natural gas storage levels were at the high end of historical averages. That glut kept prices depressed. But drawdowns of gas in storage have been running at higher-than-average levels for the last couple weeks, pulling inventories lower.

The recent rally in gas prices has been driven mainly by weather, but we may be seeing the first signs that falling Canadian drilling activity, US production cutbacks and decreased LNG imports are having an impact on US supplies. Tightening supply is good news for Canadian natural gas drilling companies, such as CE Portfolio recommendation Trinidad Energy Services Income Trust ( TSX: TDG-U, OTC: TDGNF), which have been seeing their activities decline steadily in the past few years.

Gas drilling activity should stabilize in North America this year, and so should prices. This stabilization will be enough to send gas-levered services and production firms—long major laggards—sharply higher this year. And because traders don’t have huge profits to protect in these stocks, the gas-levered names aren’t as sensitive to the stock market volatility that we’ve witnessed thus far in 2008.

It’s said that nothing cures low gas prices like low gas prices: Drilling activity slows, supplies drop, and prices rise. In the short term, much depends on weather. But longer-term factors also suggest a stronger pricing environment.

They’ve been down so long, it looks like they’re going up.

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