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Consultant: Gas-to-Resid Ratio Could Set a $6 Gas Market Floor

The push and pull of high gas storage levels and competing fuel prices on natural gas prices probably means a $6/MMBtu floor for the market unless the spring and summer are exceptionally mild, according to consultant Stephen Smith of Stephen Smith & Associates. Smith said even given the current major gas storage surplus, gas prices are pretty low compared to competing fuels and unlikely to venture much lower.

"I think we are going to get some demand back from these extremely low gas prices," Smith said in an interview with NGI regarding his Weekly Gas Outlook to clients. "For my models to work right over the last several weeks there had to have been some industrial demand returning; otherwise they make no sense. Just looking at the last couple of storage withdrawals, they tell you there has to have been some demand coming back."

Furthermore, he said a 300 Bcf storage surplus compared to historical levels is needed to keep the market in balance in the post-2004 gas market environment. According to Smith, last year's working gas level of about 1,628 Bcf (Feb. 24) might serve as an equilibrium level. At that point last year, working gas in storage was about 297 Bcf above the five-year average and about 425 Bcf above the 10-year average (from January 1994 through 2003).

Currently working gas levels, however, are about 344 Bcf above levels at the same time last year, and that has been largely responsible for the recent price decline.

On the other side of the equation is the price of crude oil, distillate and residual fuel oil. Over the last week, New York 1% sulfur resid prices fell about 4 cents/MMBtu to $7.54, but Henry Hub gas prices dropped 68 cents to $6.71, increasing the gas-to-resid price spread to 83 cents from about 19 cents the week before. "These were the first negative gas-to-resid spreads in the last three years," Smith said.

"Our base case scenario expects gas storage to exceed 1.6 Tcf on March 31 -- about 0.7 Tcf over 10-year norms and almost 0.4 Tcf over March 31 last year," he said. "The storage glut is likely to keep gas prices at equivalence with NY 1% residual fuel oil prices or below for much of the summer. The severity of summer heat and potential summer hurricane activity are the key factors that will influence the duration of the impending spring/summer storage surplus."

Smith said resid and crude oil prices should weaken from current levels, but given that it's unlike that the geopolitical factors influencing crude are unlike to go away anytime soon, crude and resid prices probably won't move much lower. As a result, natural gas will have difficulty moving much lower without significant help from mild spring and summer weather, according to Smith.

Ron Denhardt, a consultant with Strategic Energy and Economic Research, agreed, noting that natural gas prices will have trouble getting more than $1.50 below current resid prices ($7.66/MMBtu last week) and staying there for very long. "There was a period where natural gas dropped about $1.50 below 1% resid for four or five months in 2001-2002 when we had the really high storage levels," said Denhardt. "But we've never had 1,700 Bcf in storage at the end of March so...

"I said about two weeks about that I thought we could drop below $5.50. But when you get down to that level gas prices start competing with coal." As usual a lot will depend on the weather over the next several weeks, he said.

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