The price of US natural gas has hit record lows, but with storage fit to burst and demand in the doldrums, any hope of a price pick-up may remain a pipe dream for now, writes Pauline McCallion Great things could lie ahead for the natural gas sector if US dreams of a greener future come to fruition. As a relatively clean fuel, natural gas could potentially play a huge role in helping to reduce carbon emissions. However, the final legislation has yet to be drafted and passed by Congress and, even then, it will probably take some time to design and establish a carbon cap-and-trade scheme. In the meantime, some pretty bearish demand fundamentals face the already over-stocked US natural gas sector. Oversupply has plagued natural gas prices in recent months. The Henry Hub spot-market price fell by 51 cents to $2.25 per million British thermal units (MMBtu) on Wednesday September 2, the lowest point since the February 2002 price of $2.18 per MMBtu. Futures contracts for delivery during the upcoming US heating season (November 2009 to March 2010) fell by an average of 41.2 cents per MMBtu during the week ending September 2. The February and March 2010 contracts were trading at $5.030 and $5.027 per MMBtu, respectively, during that time. In its weekly update, the US Energy Information Agency (EIA) pointed out that the heating season strip was trading at a premium of about $2.50 per MMBtu to the Henry Hub spot price by September 1, providing suppliers with an economic incentive to inject natural gas into storage. Indeed, as of August 28, working gas in storage was at 3,323 billion cubic feet (bcf), with current stocks exceeding the five-year average by 17.8% and last year’s levels by 17.3%. A perfect storm Storage is building due to relatively low levels of demand. According to the EIA’s August Short-term energy outlook, the first half of 2009 saw an estimated 3.8% decline in daily average natural gas consumption, compared to the first half of last year. This was principally driven by a decrease in industrial activity, reflected in a 17% year-on-year decline in the EIA’s natural-gas-weighted industrial production index during the first half of 2009. A colder than usual summer in the US resulted in less need for air conditioning and so lower electricity demand. The relatively calm hurricane season this year also affected the demand outlook by reducing fears of a halt in supply. These demand and supply issues have combined to create “a perfect bear storm” according to Phil Flynn, vice-president, energy analyst and gereral market analyst at PFGBEST, who believes the market could be entering a new era of lower prices as a result. “Everything has come down on the bear side recently,” he says. “Even though the oversupply has come in somewhat in recent weeks, it remains well above the five-year average. This is because of production improvements resulting from new drilling techniques, such as horizontal drilling and the shale discoveries.” In June, the Potential Gas Committee (PGC), an industry association affiliated with the Colorado School of Mines, revised its current estimate for total potential US natural gas resources upwards by 39% from its previous assessment – increasing it from 1,320.9 trillion cubic feet (Tcf) in 2006 to 1,836.4 Tcf by the end of 2008. The PGC attributed this – the highest evaluation in the Committee’s 44-year history – to a reassessment of shale-gas plays in the Appalachian Basin, as well as the Mid-Continent, Gulf Coast and Rocky Mountain areas. While the report does not predict a timetable or market price for future discovery and production, John Curtis, director of the PGC’s Potential Gas Agency, calls the US gas supply outlook “exceptionally strong and optimistic”. The bulk of the optimism comes from US shale plays, such as Barnett Shale in Texas and Haynesville in Louisiana, which account for 33% of potential US gas reserves, according to the report. New technology has allowed producers to explore, drill and extract in these areas once classed as unconventional and therefore impractical or uneconomical to develop. With the long-term outlook one of ample supply, bulging inventories could soon begin to cause problems. A recent research note from the commodities team at Barclays Capital said the storage situation was “quickly approaching a train wreck”. While the report predicted a marginal rise in demand combined with a decline in domestic production, it said this would be “too little, too late” in avoiding a test of storage infrastructure capacity. Future production shut-ins are likely to be due to operational constraints, such as insufficient storage capacity, rather than the low prices seen of late. While shut-ins could tighten supply, an increase in demand is also needed to help dissipate the current over-supply. Demand has certainly not been abundant in recent months, however. “With the economy still not picking up, with new gas coming online [from the shales], storage about a month ahead of last year’s accumulation rate, and no hurricane season to speak of, we just don’t see a bullish case for natural gas prices,” says Walter Zimmerman, senior technical analyst at Icap’s United Energy. “Our analysis suggests we should not expect any sustained rebound in the economy until after 2012,” Zimmerman adds, during which time he says even more shale gas will come on line. Once the economy does recover, he questions how long it will take for demand to return to pre-financial crisis levels. Fred Lawrence, vice-president of economics and international affairs at the Independent Petroleum Association of America (IPAA), says: “The challenge for producers in the near term will be to get some kind of market back because we’ve lost a lot of industrial demand over the past year and power generation can’t carry all the extra load.” While there is some optimism going into the winter that demand will pick up, challenges remain, according to Lawrence, principally in the form of competition from Canadian natural gas and Asian LNG imports. He adds: “Many producers feel unsettled right now because the commodity price has collapsed, but tighter financial conditions are also a concern – lending terms and budgets. Leases have expiry dates and they have to produce before they lose the lease.” Going green One factor that could play a part in boosting demand is the introduction of climate change legislation that includes a federally mandated cap on carbon emissions. The American Clean Energy and Security (ACES) Act passed in June by the House of Representatives would limit aggregate emissions for all covered entities to 17% below 2005 levels by 2020, 42% by 2030 and 83% by 2050. The Senate will debate similar legislation in the autumn. Since emissions from natural gas are nearly 50% less than those for coal, it could play a crucial role in any future US clean energy generation mix, especially given the lack of commercially viable carbon capture and storage (CCS) technology currently available to help coal-powered generators reduce emissions. Estimates vary, but a commercial CCS solution could still be between 10 and 20 years away. According to the latest figures from the EIA, 91% of coal used in the US currently supplies the electric power sector, compared to 29% of natural gas supply. While the general consensus view is that a mix of sources will be required to satisfy future energy demand and reduce emissions, natural gas could play a key role in a low-cost, low-carbon energy portfolio. America’s Natural Gas Alliance (ANGA) is an industry grouping of 28 independent exploration and production companies that was established to drive such benefits home to legislators currently debating and drafting US climate change legislation. ANGA’s president, Rod Lowman, explains that of the 1 million megawatts (MW) of installed electric power generating capacity in the US, about 400,000 MW is fuelled by natural gas and approximately 312,000 MW burns coal. However, coal-fired capacity tends to be about 75%, compared to 25% for natural gas. “You don’t need to build new generating facilities or modify coal-generating facilities,” he explains, “the generating capacity is already out there, connected to the grid. So, by flipping a switch you immediately lower carbon emissions by about half.” In addition, Lowman adds that the abundant supply of natural gas in the US will diminish price volatility. However, the ACES Act concentrates more on clean coal solutions than on the use of natural gas to limit emissions. Lowman, acknowledges this fact, and adds: “ANGA was coming together when the Waxman-Markey [ACES] legislation was being developed so we did not have any impact. But we certainly learnt from that experience that the legislation did not recognise either the abundance or the clean benefits of natural gas and we’ve been very engaged in the Senate debate.” Lee Fuller, the IPAA’s vice-president of government relations, argues that the bill-making process was too politicised, taking the debate away from the “logical solution” of using natural gas. While there are similar concerns about deal-making in the Senate, Fuller is more optimistic about it. “In the Senate you’re dealing with broader interests because Senators represent states rather than districts. A number of the key votes that climate supporters will be seeking will be those of centrist democrats from strong natural gas-producing states. I believe we’ll have a better opportunity this time to have natural gas issues discussed more extensively and considered more aggressively,” he says. There will be new markets for natural gas in the long-term because of its low price and abundant supply, according to PFGBEST’s Flynn, but in the short term, demand will be lacking. “There is a point at which we need something to drive demand; unless we get a weather event or a very cold winter, I don’t see that in the short term. There have been significant changes in the market because of these new production techniques and the availability of natural gas, and I think that we’re going to see a steady market as a result. We are probably in a new era of lower natural gas prices.” The cost of regulation Natural gas producers and consumers are concerned that proposals to regulate derivatives could affect their hedging capabilities and eventually hurt investment in exploration and production. Government proposals for the regulation of over-the-counter (OTC) derivatives, published in August call for all OTC transactions to be cleared, and all standardised transactions to take place on a regulated exchange. In order to encourage the latter, higher margin requirements would be imposed on more customised transactions that are carried out off-exchange.However, producers and consumers of natural gas believe these regulations could increase hedging costs or even prevent them from using derivatives to manage risk at all. Many feel it is imperative that any new regulatory proposals acknowledge the benefits that can be gained from OTC trading when it is conducted for the right reasons and in a responsible way. End-users are mainly concerned about being lumped in with policy-makers’ current bogeymen: speculators. Natural gas producers and users typically use the OTC market because they can structure long-term deals using their reserves as collateral. Exchanges, on the other hand, generally require users to post cash margins. “There could be significant incremental cash collateral requirements from time to time that would add to financing costs,” says Jack Dybalski, vice-president and chief risk officer at US utility Xcel Energy. “We don’t incur those costs currently because our physical suppliers and OTC counterparties largely give us open credit.”He adds that clearing fees and rising brokerage fees could also affect the bottom line for producers and users of natural gas. Similar concerns were voiced in July in a joint letter to the Senate by a group of 15 gas and power trade bodies, including the Independent Petroleum Association of American (IPAA), Edison Electric Institute and America’s Natural Gas Alliance. They argued that the cash margin requirements imposed by a clearing house or exchange would increase transaction costs, diverting funds that could otherwise be invested in new energy infrastructure at a time when the cost of capital is high and access to capital markets is uncertain. “Any volatility in energy prices would put enormous demands on producers’ financial resources [if they had to trade on an exchange] and defeat the purpose of hedging, which is to give some certainty to cashflow and allow producers to take those resources and put them into exploring and finding natural gas and oil,” adds Susan Ginsberg, IPAA’s vice-president of crude oil and natural gas regulatory affairs. Aubrey McClendon, chairman and chief executive officer of gas producer Chesapeake Energy, echoed this concern during an August 4 conference call on the company’s second quarter results. “Our basic approach is, if you want to reduce the industry’s ability to mitigate risk, then you’re going to reduce the industry’s ability to invest dollars and that will cause supply to go down and price to go up,” he said. For many industry participants, recent CFTC discussions about setting position limits and increasing transparency in energy futures would be preferable to forcing OTC transactions onto exchanges. Ginsberg argues that regulators should take the process one step at a time. “There is a little bit of concern that a lot of proposals are playing out at the same time,” she says. “I think there is a general consensus that there should be greater reporting, but we would prefer to see how the use of position limits works first.” ...
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