Every week when I prepare my Weekly Report, I try my best to present a balanced point of view.
To the extent time and space permit, I usually try to present both the "bullish" and "bearish" case as to what might happen next in the market. I do this in part because, no matter how strongly the fundamentals might dictate that prices move in a particular direction, the market can and often will take a different perspective. It is essential, therefore, at all times to be mindful of how those different perspectives might drive the market at any particular point in time. At the same time, over the past several days, it has seemed to me increasingly that, in focusing as I often do on the normal week-to-week metrics, and discussing how the Weekly Storage Report and/or other specific pieces of data might be interpreted as “bearish” or “bullish” indicators, like many analysts, I may sometimes risk losing sight of the forest for the trees. In this week’s Report, I certainly will continue to try my best to maintain my objectivity and balance. Over the past few days, however, as I’ve tried to step back and look at “bigger picture” issues, a number of factors stand out that cause me to conclude that, as high as natural gas prices may be currently, we still are virtually certain to see steep further increases over the remainder of this year – quite possibly beginning very soon. The specific factors that cause me to reach this conclusion are discussed in detail in the Market Analysis & Commentary Section of this Report. They include, however, the following:
- While natural gas prices are high, even at this week’s levels, the cash market price for natural gas is no higher than it was in May of last year. Further, prior to the 40 cent/MMBTU jump in the cash market price earlier this week, it was only modestly higher than the price levels that have been typical for much of this past year. At the same time, the manufacturing sector is showing far more strength than it was a year ago, and certain natural gas intensive industries (including the steel and aluminum industries) are showing an extraordinarily high rate of growth. As a result, while there have been declines in natural gas consumption in certain specific industries, on an overall net basis, manufacturing sector consumption of natural gas almost certainly is at least as high as it was a year ago and quite possibly higher. The likelihood that there has been a major net reduction in manufacturing sector use of natural gas appears to be remote.
- At the same time, as we enter into the summer months:
- Power sector demand for natural gas (the largest natural gas-consuming sector of the economy) is virtually certain to be at least 3 to 4 BCf/day higher than last summer – with the potential for even larger increases if the summer is hotter than normal and/or any of a variety of factors force generation owners to limit the output of coal-fired plants;
- Based upon 1st quarter 2004 reports by publicly reporting E&P companies (which account for 2/3rd’s of U.S production), U.S. natural gas production appears to have declined by as much as 2.5 BCf/day compared to last year. Despite continued increases in new drilling, every E&P company executive to whom I have spoken expects further declines over the course of this year;
- Imports of LNG are likely to increase only marginally compared to last summer (since by Q 3 of last year imports of LNG already had increased significantly compared to earlier levels);
- Imports from Canada are likely to be flat or declining;
- Exports to Mexico could well increase, at least modestly; and
- Oil prices are at a 13-year high – and at risk of heading higher once we move out of the current period of relatively slack demand.
- Further, while there undoubtedly is some price at which current industrial users of natural gas will begin to significantly curtail current use, that price almost certainly is significantly above last year’s levels.
- Last year’s late April storage levels were among the lowest ever. Current figures look high relative only to an abysmally low standard.
- In fact, last week’s storage level actually was the third lowest late-April figure in the last 6 years. It is 451 BCf below the amount of natural gas in storage as of the same week two years ago and 34 BCf below 5-year average levels.
Except for last year, the only other year when the same-week figure was lower was April of 2000, when storage as of the same week was 947 BCf (208 BCf below last year’s level). That year, of course, like this year, the economy was booming. Notably, even though U.S. production was then at its peak (with total U.S. production at least 1.0 TCf above current levels) , by the end of the year natural gas prices quadrupled – with the spot market price for the first time exceeding $ 10.00/MMBTU.
- Last year, the impact of record low late-April storage was largely offset by milder-than-normal temperatures in most major urban centers in the eastern U.S. in June and early July (and therefore much lower than normal power sector demand for natural gas during this period).
As discussed in earlier Weekly Reports, these milder temperatures resulted in a massive year-over-year decline in power sector demand for natural gas in June and July, particularly in the East North Central Region, the Mid-Atlantic Region, the Southeast Region and the South Central Region, which was largely attributable to weather. This year, however, there is no reason to expect a similar weather-related decline. Instead, there is substantial reason to expect a steep year-over-year increase in power sector consumption of natural gas during the same period, since the economy is growing at a rapid clip and consumption during the same months in 2003 was depressed by atypical weather in core urban areas, where most of the summer air conditioning load is centered. These increases in power sector demand for natural gas could be even steeper if temperatures are hotter than normal and/or operation of some coal-fired plants is curtailed, as some forecasters are now predicting will occur.
- Finally, as noted in last week’s Report, despite all of the weight being given to the additional amounts of natural gas currently in storage levels, in the end the net impact of this incremental storage is to reduce the amount of natural gas that must be purchased by LDC’s for injection into storage in the two Consuming Regions between now and the end of the Refill Season by an average of only 1.0 BCf/day.
In the end, therefore, I believe that the evidence is unmistakable that the supply/demand balance in the U.S. market is deteriorating rapidly, and that a substantial further price adjustment will be required to bring the market back into equilibrium. An academician (which I decidedly am not) will doubtless object to the assertion I have just made that a major further increase in prices is necessary to bring the market back into equilibrium, and claim instead that the market (being efficient, as academicians assume every market is) must be aware of all that I have just said and already must have priced all of the factors I’ve identified into the market price of natural gas. And it is, of course, possible – at least in theory – that this is exactly what has occurred (i.e., that the effect of the recent run-up in futures prices and the accompanying run-up in the cash market price is to price into the market everything I have just described).
Only time will tell whether this has occurred.
My own experience over the past several years, however, is that most oil and gas analysts still thoroughly misunderstand the impact that changes in power sector demand for natural gas have had on the natural gas market – even though these changes have been the most important factor affecting the market for several years, played a particularly critical role last year and, if anything, are likely to play an even more important role in 2004. I’ve yet to read any analysis that, at least in my judgment, correctly evaluates the factors listed above.
If the full-time professional analysts who follow the industry most closely, however, are far off the mark in assessing factors affecting supply and demand, its difficult to see how the market as a whole could nonetheless be expected to accurately price in the dislocations described above – especially since the market has never previously experienced dislocations of quite this nature or magnitude. Instead, my overall sense of how the market is currently pricing natural gas is quite different. The cash market price currently is at an all time high for the first early May. Earlier this week, most months’ futures contracts’ also set new contract highs. At the same time, however, despite these extraordinary circumstances – and despite the fact that oil prices are at a 13-year high – I believe that fundamentally the market as a whole is quite skeptical of the fact the potential for natural gas prices to go any higher.
In other words, despite all of the evidence discussed above that the natural gas market is likely to get even tighter as we move into the summer air conditioning season – i.e., that the economy is booming, that supplies are continuing to decline and that electricity demand is running far above last year’s levels – fundamentally the market is acting as if prices are likely to top out very near to where they are now, with very little likelihood that prices will go much higher.
Notably, for example, a heart-of-the-summer August natural gas futures contract, covering a period when power sector demand for natural gas is likely to average 4 to 5 BCf/day higher than it is in June (and on some days could wind up being 10 BCf/day higher), and the economy will have experienced 60 days of additional growth, is still selling for only about a 10 to 12 cent/MMBTU premium over a June contract, when the pressure on the spot market price is not likely to be nearly as intense. Similarly, the premium for moderately out-of-the money August or September call options is also relatively small (and, at least as we calculate it, significantly under-priced using the Black-Scholes Model for pricing options) -- even though the volatility for natural gas contracts is huge. Further, the NYMEX futures market generally has been proceeding very gingerly each time it approaches a new resistance point.
In a sense, this skepticism on the part of the market is healthy; it suggests that the market is less likely to race upward in runaway fashion than it has at times in the past (and therefore hopefully will be somewhat less prone than it has been in the past to sudden collapse). At the same time, at least in my judgment, it suggests that the market has not yet really begun to price in the fundamental drivers listed above. Much has changed since I first started writing these Weekly Reports 10 months ago – almost none of it for the good (in terms of there being any reasonable basis for hoping that increases in natural gas prices can be kept within tolerable limits during the remainder of this year).
The economy, which had been dormant for so long that it was becoming unclear whether it would ever revive has taken off with the strongest burst in the manufacturing sector in almost 20 years (fueled in part by the end of the war risk and by U.S. funding of the effort to rebuild Iraq). This is great for the welfare of most Americans. However, it inevitably means significantly higher industrial consumption of natural gas than would have occurred otherwise and is also leading to the strongest growth in electricity demand in decades. Further, this strong growth in electricity demand for the first time is occurring at a time in which we are now totally dependent upon natural gas-fired generation to meet virtually all of our incremental electricity requirements in many regions of the country during an increasing number of hours every year. At the same time, over this same 10-month period, both U.S. and Canadian natural gas production – which collectively account for 98 % of U.S. supply – have deteriorated at an even more rapid rate than even the most pessimistic among us feared. And oil prices are almost 50 % higher than most experts were predicting just a few months ago. Despite all of this, the cash market price is still priced below where it was on May 15th of last year – and until earlier this week, within 30 to 40 cents/MMBTU of where it has been priced for most of the past 12 months. Fundamentally, therefore, I do not believe that the market has yet priced in any meaningful way the dislocations that are about to occur over the next 60 to 90 days. Instead, I think that was has happened is that, twice now – last May and June, and again this past December and January – the market has skated to the edge, in the sense that it raced towards very high prices (i.e., a peak of $ 6.41/MMBTU in the cash market last summer, long stretches between $ 6.50 – 6.75/MMBTU this past winter) and then pulled back.
Both times, as both Matt Simmons (who I admire greatly) and I have each separately written about, “good luck” regarding the weather kept us from going over the precipice (i.e., kept from prices exploding to much higher levels). Last summer, it was the mild weather in the urban centers in the east in June and July (along with a number of other factors discussed in the earliest of my Weekly Reports). This past winter, it was a combination of very mild weather in November (which allowed us to build up an extra storage cushion of around 125 to 150 BCf in November), mild weather in late December and early January, and decisions by LDC’s beginning in mid-January to begin pulling down heavily on storage in the East Consuming Region, relieving the pressure on the spot market price of natural gas (but increasing the burden these same LDC’s will face in refilling storage now). In each instance, however, if weather-related demand had been just a little bit greater, prices easily could have been pushed much higher.
The “market,” however, didn’t fully appreciate in either instance just how close we came to seeing $ 8.00/MMBTU prices – and similarly isn’t yet pricing in now any recognition of how close we are to seeing $ 8.00/MMBTU prices again. This time, however, I believe circumstances are different than the last two times we “skated towards the edge,” in at least two important respects:
- This time, as discussed in the Market Commentary Section of my Report, heading into this summer, the imbalance between supply/demand is so severe that no amount of “good luck” regarding the weather is likely to be able to keep us from experiencing severe price dislocations in the market;
- To make matters worse, it is not at all clear that this time our string of “good luck” regarding the weather is likely to continue. Instead, there are increase indications that: (i) temperatures this summer may be hotter than normal over large sections of the country (including several of the most gas-sensitive regions); and (ii) hydro conditions may prove to be especially poor, not just in the Pacific Northwest but in other regions as well.
- There is a high risk of record prices for natural gas, electricity, coal and oil; and
- Every energy company and every major energy user should be giving very high priority to: (i) evaluating the extent of this risk; and (ii) if appropriate, developing a strategic plan to protect the company, its customers and its shareholders against this contingency.
To the best of my knowledge, however, very few companies are taking these steps. Dow Jones newswire reported today that electricity production for last week was 69,245 Gigawatt hours – 1.6 % greater than last week and 6 % higher than the same week last year. (Note that the weather-related load both years was very similar.)
Last year, electricity production did not reach this level until mid-June. This year, by mid-summer, electricity production could average 3,500 to 4,000 GWhrs per week higher than last summer every week – and could be up to 10,000 GWhrs higher than last year in some weeks if we have any “killer hot” summer weeks (which by and large last summer never occurred). By late July, it is possible that we will have a series of weeks in which we will set a new U.S. record for electricity production every week for several successive weeks, with virtually all of the incremental electricity production compared to last year served by increased use of gas-fired generating units.
It is even plausible that in one or two weeks this summer we could have a small net withdrawal from storage rather than the typical summer-time injection. As we’ve discussed in the last several Weekly Reports, these figures carry an important – I believe critical – message for the industry.
In a natural gas market that is tight as a drum, with supply declining and the manufacturing sector humming, it is not realistic to expect that we can have increased pressures on the natural gas market of this nature without intense upward pressure on the price of natural gas – and therefore, in the summer months, the wholesale price of electricity as well. Under these circumstances, the 40 cent/MMBTU increase in the spot market price that occurred earlier this week could soon look tame.
It is essential, therefore, that more companies begin paying attention to this message at the earliest possible date.