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Strong Gas Prices Based on Projected Production Declines

There appears to be a sea change in the making for the natural gas market as the focus shifts from the current mild weather and almost full storage to projections of a rapid fall-off in production. Analysts now are warning of a gathering storm in the form of higher prices this winter and into 2010, particularly if the economic recovery puts more industrial demand back online.

Market watchers -- who only a few months ago were issuing dire predictions of a "train wreck" in prices during September or October when storage would top out ahead of schedule -- now are back-pedaling in the face of the overall strength in both cash and futures numbers during the past couple of weeks.

There still is time for the earlier predictions to play out at least briefly next month if there is mild weather and no room left in storage. But there is some doubt as to what really constitutes full storage, and the analysts and the futures market appear to be looking beyond the bumps in the road to a new supply situation.

It's possible that high pipeline linepacks will cause involuntary production shut-ins in the near future, as predicted in a late-August report by Barclays Capital (see NGI, Aug. 31). But a few weeks ago the Energy Information Administration increased its projection of total working gas capacity from about 3,750 Bcf to 3,900 Bcf or so (see NGI, Sept. 7), and some people think that estimate is conservative, said Cameron Horwitz of SunTrust Robinson Humphrey. They think 4,000-4,100 Bcf "could be shoved into storage."

Looking beyond the bumps, analysts at Tudor, Pickering & Holt Co. commented, "If natgas were a stock, we'd say it was signaling an upside earnings surprise or some good news. Refuses to go down with bad news (filling storage). Surprisingly strong and nobody knows why...Street focused on full storage...but three months ago it looked like 4,200 Bcf full. Now only 3,900 Bcf full."

Fast forward to early 2010 and Canadian analysts in particular are seeing production declines hit the market with a vengeance. Peter Tertzakian of ARC Financial Corp., Calgary, believes increased production of shale gas plays, coupled with the return of production from the Gulf of Mexico that had been knocked out in last year's hurricanes, have been masking a steep drop in conventional production (see separate story).

"The billion-dollar question for 2010 is whether or not unconventional gas production in now-legendary plays like the Barnett, Haynesville, Fayetteville, Woodford, Marcellus and even Canada's Montney, to name a few, will be able to collectively respond fast enough to offset estimated conventional declines in 2010 of 5 Bcf/d in the U.S., plus another 1 Bcf/d in Canada. Theoretically it's possible..." but economic and logistical constraints could put a lid on unconventional production through 2010.

"Next year it's quite possible that only half of the expected 6 Bcf/d of conventional losses in North America will be replenished. It's a scenario that speaks to benchmark continental prices rising above US$6/MMBtu again, all else being equal," Tertzakian said. Plugging the lay-down of drilling rigs in conventional fields into his models supports a precipitous fall-off in conventional supply. Ultimately shale gas will fill the gap, but not next year.

Another Calgary firm, FirstEnergy Capital Corp., conveying the Canadian industry mood in research notes to investors, has called attention to the unprecedented Canadian supply "collapse" over the last year, but it noted that it's one with at least a potential "silver lining."

The investment house maintains commodity markets are seriously underestimating the international scale of the Canadian gas supply erosion by keeping prices at severe lows in an industry hardship range of $3-4/MMBtu, and are thereby setting the stage for a surprise rebound toward the $7-8 range needed to light a fire under drilling as early as the first quarter of 2010.

"This Canadian supply story is simply not getting through to many on the Street [commodity futures and stock exchanges] in terms of its magnitude and duration," FirstEnergy said. "The declines we have seen and are contemplating for western Canadian natural gas production are far greater than many realize and this will make a difference in shifting gas balances for North America over the coming heating season, in combination with declining U.S. supply and modestly improving natural gas demand" (see separate story).

There was also some perception that futures traders built up large short positions over the summer in anticipation of a possible fall price collapse and now are being required to retire some of those positions because prices are remaining strong for the most part.

Meanwhile, SunTrust Robinson Humphrey commented in its Thursday advisory that "many market pundits are puzzled by the recent rise in gas prices given elevated storage levels; however, we remind investors that it is the incremental changes in underlying supply-demand fundamentals that should overridingly govern natural gas prices. While the extreme weakness in prices seen in August was likely attributable to concerns over physical storage limitations, it appears the market is increasingly pardoning high stockpiles and instead looking 'across the valley' at accelerating supply declines and improving industrial gas demand...Throw in recent forecasts calling for a relatively mild El Nino with the potential for colder-than-normal weather in the back half of the heating season, and the recent strength in gas prices appears rather sensible in our view."

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