Natural gas prices aren't coming down anytime soon, at least according to the latest reports by two energy analysts last week. Raymond James last week suggested that the "fair value" for gas may run as high as $10/Mcf, while Stephen Smith Energy Associates pegged gas prices to end the year around $7.85/MMBtu.
Both reports are bullish in comparison with recent forecasts by Bentek Energy LLC and the Energy Information Administration (EIA). Denver-based Bentek said last fall that with new drilling in the Rockies, prices could fall as low as $3/MMBtu later this year (see NGI, Dec. 13, 2004). The EIA in June forecast prices to remain in a range of $6.50-7/Mcf through the summer and end the year around $7.50 (see NGI, June 13).
According to Raymond James analysts, as year-over-year weather comparisons become more favorable and surplus natural gas currently available shrinks on increased demand, the price ratio between oil and gas should "at least" approach Btu parity of 6:1 and possibly get narrower over the next six months. With front-end oil futures near $60/bbl, "that means the fair value for gas is about $10/Mcf, not $7.36," which is the current price of front-month gas futures.
Raymond James analysts noted that "under a normalized weather scenario, we would expect the price of gas to move much closer to that of heating oil by early 2006. Assuming that crude stays near current levels, this would imply gas at above $10/Mcf. Accordingly, if and when gas approaches parity with heating oil, the oil/gas price ratio should approach the 5.5:1 level."
Over time, Raymond James analysts continue to believe that the oil/gas price ratio should ultimately converge to around 6:1. "Given the incremental costs of burning oil-based fuels and the relative scarcity of gas during the winter season, one could even argue that the ratio should be closer 5.5:1 over the longer term. U.S. natural gas prices are depressed due to mild U.S. weather over the past year."
The analysts noted that a "substantial" amount of gas demand was lost relative to normal weather. "The demand destruction created enough oversupply in the gas market to depress gas prices relative to oil. Given that abnormal weather has driven gas prices lower, we do not believe that the current price ratios are permanent."
Oil/gas price ratios have been narrowing for 15 years, the analysts wrote. The 1990s, they said, began with a ratio near an "astonishing 20:1 but ended with a much more reasonable 8:1." The ratio has been stable in recent years, but generally has been below 8:1 and sometimes as low as 4:1.
"Obviously, over the past 15 years, both oil and gas prices have increased massively. However, the key point is that gas prices have increased much more in percentage terms," the analysts said. For example, they noted that gas prices in June 2005 were, on average, five times higher than in June 1990. On the other hand, oil prices were only about three times higher. As a result, the price ratio compressed and is now closer to Btu parity.
"Though the price ratio has varied over time, it has displayed a distinct underlying downward trend. The reason for this trend is simple: This country is running out of (natural) gas. To put a less dramatic spin on it, the U.S. gas supply bubble -- which had been present throughout the 1980s and early 1990s -- has now been completely worked off. We estimate that domestic gas production peaked in 2001 or 2002, and has been declining ever since, by about 2% to 4% per year. Despite the 40%+ increase in drilling activity over the past two years, there has been almost no supply response, except merely to moderate the rates of decline."
Raymond James analysts said that similar to the 1970s, when domestic oil production continued to fall, regardless of how many rigs were drilling, "we think we are nearing (if not at) a similar crossroads in the U.S. gas supply picture."
In another take on gas prices, Stephen Smith's latest forecast said that with spot crude prices rising at a stronger-than-expected pace, actual cooling degree days (CDDs) about 13% higher than a year ago and the natural gas consumption impact per CDD above 2004, the stage is set for continued upward pressure on gas prices for the next few months.
The energy consultant said in his June report that the odds "favor some if not all of these factors influencing gas markets for the full summer. In addition, there are expectations for a stronger than normal hurricane season. All of these factors taken together appear to set the stage for upward pressure on gas prices for the next few months."
Smith is forecasting third quarter Henry Hub gas prices to average $7.40/MMBtu, and for the fourth quarter the forecast is $7.85/MMBtu. Smith's resulting average annual bidweek Henry Hub price forecast for 2005 is $7.05/MMBtu, well above an earlier forecast of $6.40/MMBtu.
Smith said that higher prices for oil "may have had more to do with the recent strength in gas prices than the decline in the gas storage surplus that we have seen thus far. But if the warmer-than-normal weather continues, as projected by many weather forecasts, the erosion of the gas surplus could become the more dominant driver of upward gas prices movement as the summer progresses. The 'surplus reducing' impact per CDD-above-normal appears to have increased by 5-6% for this summer as compared with last summer."
Smith noted that the gas storage surplus has declined from 420 Bcf (over 10-year norms) on June 3 to a projected 338 Bcf for the week ending July 9. "This spread, however, is still well below the $1.50/MMBtu that existed in June 2004 because the current storage surplus, while declining, is still about 140 Bcf above year-ago levels."
Smith said that post-2003 seasonal storage preferences are "perhaps 200-250 Bcf higher than historical seasonal norms. If adjusted for these new storage preferences, the projected July 8 surplus would be only 88-138 Bcf. Given that the surplus is projected to be reduced by a total of 82 Bcf for the five weeks ending July 8, with an expected total of 38 CDDs above normal for this period, the adjusted 88-138 Bcf surplus does not appear so large that it could not be eliminated by fall."
If the ratio of 2.15 Bcf of surplus reduction per CDD-above-normal were to hold going forward, Smith noted that the 138 Bcf of surplus could be eliminated by early October with CDDs of only 4.9% above normal. And, he added, "the National Weather Service and all private weather forecasters (that we know of) are forecasting a hotter than average July through September."
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