The days of $3/MMBtu natural gas may be gone, but with unconventional U.S. production economic at $6-7/MMBtu, medium-term domestic prices aren’t likely to match the $18-20 highs fetched by liquefied natural gas (LNG) cargoes overseas — which in turn could deter some LNG imports for as long as five years, according to energy analysts.

Crude oil prices may have grabbed the headlines with their run above $140/bbl, but U.S. natural gas prices have experienced a banner year in their own right, said Lehman Brothers energy analysts Daniel Ahn and Ed Morse. U.S. contract gas, they noted in a special report on energy, has surged to record summer highs, with gas for August delivery up 72% since the beginning of the year to $13.57/MMBtu on July 3, followed by a week-long retreat of 12.5%.

“Despite this year’s increases, U.S. gas is still at a significant discount to prices elsewhere in the world, which have diverted LNG supplies away from the U.S. market,” the analysts noted. European consumers benchmark gas against petroleum-based products while Asian buyers link gas to crude oil prices, and the gains in crude prices since 2006 “have combined with a series of events to push those gas markets to new heights.”

The earthquake in Japan last year removed almost 8 GW of nuclear capacity from the country’s grid until at least 2010, which has forced generators to rely more heavily on gas, said Morse and Ahn. In addition, colder-than-normal winters in Korea and Turkey were followed by a drought in Spain, which decreased hydroelectric capacity and further led to increased global demand for LNG. “In this tight atmosphere, LNG cargoes have fetched prices upwards of $18/MMBtu as Asian buyers have paid a premium to draw LNG from as far away as Trinidad,” they wrote.

About halfway through 2007 Henry Hub gas was trading at a discount to West Texas Intermediate crude, with gas priced at around 83% of oil on an energy equivalent basis. By the beginning of this year, the analysts noted that gas prices had fallen to less than half of oil prices and have since failed to breach the 60% mark — despite record-high summer gas prices. “While some observers have been awaiting a convergence of gas with oil prices, the U.S. gas market has remained disconnected due to unconventional gas production and lack of liquefaction capacity to send natural gas exports abroad,” said the Lehman duo.

Unconventional gas production, including shale, tight sands and coalbed methane, “has more than compensated for a dramatic decline in production from the shallow waters of the Gulf of Mexico,” said Ahn and Morse. “Shallow water operations, which accounted for 20% of domestic production in 2002, have since fallen by more than half to 4.8 Bcf/d this year. Gas from unconventional sources, by contrast, has grown by 68% over that period and this year will account for more than half of U.S. production for the first time.”

This new source of supply “has helped to insulate the market from even larger jumps in prices experienced in Asia and Europe. The divergence of U.S. gas from global gas (and oil) markets is evident in the drying up of LNG imports in the U.S. as higher prices have attracted cargoes to other markets. To the frustration of companies that have expanded U.S. regasification capacity this year, LNG imports through the first half of the year were approximately 1 Bcf/d, just 38% of year-ago levels.”

Unconventional gas production, however, has not been able to entirely fill the void left by declining supply elsewhere, which is reflected in this year’s high summer prices and weak gas storage data, they noted.

“Apart from falling Gulf of Mexico supply and the LNG drought, U.S. net pipeline imports are about to dip. Canada, which historically has supplied about 15% of U.S. gas consumption, faces sagging production, rising demand and a storage deficit of its own, all of which will drag down Canadian exports through 2009,” they said.

U.S. gas inventories for the week of July 4 stood at 2,209 Bcf, which is down 389 Bcf (15.8%) year-over-year.

For domestic storage to reach a “comfortable 3,400 Bcf” inventory level before withdrawal season begins, the Lehman analysts calculated that net injections would have to surpass the five-year average by 0.94 Bcf/d through the remainder of the injection season. “Considering that net injections so far have lagged the five-year average by 0.98 Bcf/d, reaching that comfort zone is improbable; simply reaching average injections through October would bring peak storage to just 3,281 Bcf.”

The low inventory data are supporting high prices and setting up a “potentially volatile winter market,” they aid. “The big question for the medium term is whether unconventional gas production can grow fast enough to keep up with demand growth of 1.5-2.0% while compensating for declining offshore production and sagging imports from Canada without the market turning dramatically to LNG supply. The answer appears to be yes.”

Shallow-water offshore production now represents less than 9% of domestic supply and does not have room to decline further noted the analysts. They calculated that production in shallow waters slipped by 1.8 Bcf/d in the past two years; growth in the Barnett Shale of Texas alone “has nearly offset that decline since early 2006.”

The LNG market is set to loosen in 2009 with the ramp-up of new liquefaction capacity, but U.S. LNG imports will only rebound slightly “barring weather-related disruptions or a dramatic decline in the price that international buyers will pay to attract cargoes,” said Morse and Ahn. “With new shale plays on the horizon, a convergence with oil prices may take place, but more likely because oil prices fall to earth, rather than gas rising to meet oil.”

Ed Kelly, Wood Mackenzie’s vice president for North American Gas & Power, said his research firm also has determined that U.S. onshore gas production has overshadowed LNG for the next few years. Kelly spoke earlier this month at the Rocky Mountain Energy Epicenter in Denver.

According to Kelly, LNG imports to the United States are “inevitable,” but it may be five years before the imports are needed because of burgeoning onshore gas production. Based on “conservative” estimates, he said, that is, the absence of U.S. greenhouse gas legislation and only the current list of unconventional plays in North America, Wood Mackenzie projected that the current LNG now arriving on U.S. shores will not top the current 1 Bcf/d. Over the next five years, Wood Mackenzie is forecasting that about 3 Bcf/d of flexible cargoes will arrive in the United States as the “market of last resort,” depending on world events.

However, through 2012, gas shale, tight gas and coalbed methane plays will add 5 Bcf/d to U.S. supplies. Supply will outpace demand growth through that period, said Kelly. However, beginning in 2013, power generation demand and a reduction in Canadian imports — as much as a 6 Bcf/d decline — will lift U.S. gas prices and return LNG to U.S. shores.

Unconventional gas production between 2012 and 2017 from currently producing basins now is expected to plateau, said Kelly, which would lead to a shortage in the U.S. gas market of 8-10 Bcf/d. The Haynesville Shale in northwestern Louisiana and the Marcellus Shale in the Appalachian Basin would ramp up by then, however, making up 3.5 Bcf/d of the shortfall. The remaining supply would have to come from LNG, which in turn would reconnect U.S. gas prices to the global market, said Kelly.

By 2013, “the United States will need to attract flexible LNG cargoes to make up for the plateau in domestic growth,” Kelly said. At the same time, “if we have unconventional [in North America], they have unconventional there,” he said of other nations.

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