Natural gas wellhead deliverability is weaker than many observers realize, and the natural gas futures strip is undervalued, according to Kevin Petak, director at Arlington, VA-based consulting firm Energy and Environmental Analysis Inc. (EEA). Petak believes $5 Henry Hub gas prices will arrive very soon — most likely in January or February — and prices should average $5.35 next year.

Other experts agree that $5 prices are possible sometime next year, but they doubt that winter prices will average that, as EEA predicts. In fact, Tim Evans, futures analyst with IFR Pegasus, expects prices to fall sharply at some point this month, possibly to $3.05. “I think the market does have some upside, particularly for the 2003-04 winter,” said Evans. “The problem I have is that in the short term I think the market is overvalued right here. You’ve got a storage level that is still…above the five-year average and prices also are above the five-year average.”

What the bears aren’t factoring in, however, according to Petak is the declining level of productive capacity. “I think what the other consultants are maybe missing, particularly those who think prices will go back to $3, is the underlying fact that the supply-demand balance at the end of the day is still tight.

“It kind of stumps me that other consultants are concluding that gas prices are going back to $3 in an environment where if anything the supply-demand balance is going to get even tighter. Supposedly we have an economy that is rebounding. If you look at the consensus forecast for [Gross Domestic Product] GDP, everyone is saying the fourth quarter is going to be relatively soft at 1.6% GDP, but next year everyone has it returning to 2.5% or more. If you have an economy growing where gas demand will likely grow, flat productive capacity and maybe declining productive capacity and inadequate drilling levels, how is it that prices can go down in this type of environment?

“Prices aren’t going to $5 this month, but they are going to $5 on average this winter and it’s going to be volatile. We just don’t know when it’s going to happen this winter.”

Petak said that according to EEA’s data wellhead deliverability is much lower than it was at the beginning of this year. “That we don’t see being remedied until the drilling activity rebounds. We don’t think rig activity under 900 rigs is sufficient to even replace productive capacity let alone grow it.”

He noted that stingy capital markets are exacerbating the problem for producers who desperately need to increase their E&P programs. The situation is likely to continue and as a result there will be continued upward price pressure and volatility in the marketplace, said Petak. But it will take a stretch of some cold weather to shock the market into realizing it, he said.

Some analysts have noted that the rig count and gas production are in line with historical averages, despite being down from the record highs last year. But according to Petak, natural gas productive capacity grew by only 1 Bcf/d despite the huge drilling levels in 2000-2001. “That’s our estimate. We do very detailed analysis on a lot of the gas supply information that is out there in the marketplace. A lot of the gas production information comes from IHS databases and state bulletin boards on production,” he said.

“We were drilling an average of well over 1,000 rigs in 2000-01 and this year’s average is going to be 830-840. If we only grew productive capacity by 1 Bcf/d back in that period, how are we going to grow productive capacity at all at the type of level we are at right now, which is 20% below the 2000-01 level?”

He said the small increase in productive capacity during the record drilling last year indicates there is a real problem with the quality of the resource base, and the industry is going to need a much higher drilling level just to sustain production going forward.

Quarterly reports from many producers show production down considerably from last year — as much as 6%. “The only reason that we haven’t really seen much higher gas prices is because we had no winter in 2001-02 and came out of the winter with relatively large working gas levels [in storage] and so the amount of storage refill requirements were much less and consequently there was not as much gas-on-gas competition between power providers and folks trying to refill storage so we didn’t see the price pressure.”

The current high level of working gas in storage might be depleted rapidly under normal winter weather conditions, but what about in an El Nino winter?

Tom Saal of Commercial Brokerage Corp. in Miami noted that the El Nino weather pattern could keep gas in storage and hold prices down. “Most of the forecasters are calling for an El Nino this winter. Most of the arguments are over how weak or how strong it is. But if there is an El Nino, prices are going to be on the defensive. It’s going to be a warm winter. ‘El Nino’ is Spanish for ‘low gas prices,'” he quipped.

EEA expects that El Nino may delay or slow the storage depletion rate, but the depletion is inevitable because of weak wellhead deliverability.

Petak said current gas futures strips apparently are not factoring in this underlying lack of productive capacity — the 12-month and 24-month strips have been hovering around $3.85/MMBtu, not the $5-plus levels he says prices will end up averaging over those periods.

“We’re still very early in the game; it’s very early in the winter. If we get normal weather throughout the winter, you are going to see those storage levels come down, especially in December and January.

“We think forward prices have not captured the gravity of the issue, which is that productive capacity has been falling and if the economy is headed back up demand is going to return and we’ll have an even further tightening of the supply-demand balance, which will put upward pressure on prices. I think whenever we get a stretch of cold weather and you see the EIA storage report show rather big withdrawal levels, that’s when you will see it.”

Under an El Nino winter, EEA has prices averaging $4 through February. However, by next summer prices should be much higher and annual 2003 prices should average $4.64 with 2004 moving up to $5.23 on average. For more information on EEA, call (703) 528-1900, or email kpetak@eea-inc.com.

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