Return of 'Lost Demand' Key to Future Gas Prices

As natural gas storage levels recently erased the long-standing deficit when compared to last year's levels, turning it into a surplus for the first time since January 2000, analysts are being forced to take another look at their natural gas price forecasts for the remainder of 2001 and for 2002.

Robert Morris of Salomon Smith Barney said the key to determining gas prices going forward depends on how quickly the "lost demand" returns to natural gas. Currently, Morris attributes 3.5 Bcf/d of the 5 Bcf/d of lost demand to fuel switching, when customers moved away from gas and used alternative fuels due to high composite gas prices. The remaining 1.5 Bcf/d of lost demand is attributed to reduced consumption related to economic factors.

"Even if natural gas prices returned to $3.50/MMBtu tomorrow, all of the lost demand may not immediately return to natural gas, given that part of it is related to overall economic factors," said Morris in a report released Tuesday. "Also, industrial and utility users may want to be assured that natural gas prices won't escalate again in the summer before incurring the cost and effort to switch back to natural gas."

Due to the current lost demand and increased domestic production, as well as increased imports from Canada, SSB believes that storage injections are more than 7 Bcf/d higher year-over-year, adjusted for weather as well as hydro and nuclear supply variations.

From these indicators, Morris said that SSB is lowering its full-year 2001 composite spot gas price forecast to $4.65/MMBtu from $5.00/MMBtu, while keeping the 2002 forecast at $3.75/MMBtu. SSB expects Q2-Q4 of 2001 to come in at an average of $4.20/MMBtu, $3.75/MMBtu and $4.50/MMBtu, respectively.

Thomas Driscoll of Lehman Brothers agreed that fuel switchers are key. "Gas prices may need to fall to allow increased consumption," Driscoll said in his recent report, "Natural Gas Demand Is Elastic." "If consumers need to be induced to use an additional 500-550 Bcf of gas this refill season (less increased power generation demand of 125-150 Bcf) natural gas prices need to fall further. We speculate that natural gas prices must fall low enough to cause consumers that are currently burning residual fuel oil to switch back to natural gas."

Driscoll says Lehman Bros. is now forecasting an average (Henry Hub) gas price of $5.00/MMBtu for full year 2001, with Q2-Q4 of 2001 at $4.75/MMBtu, $4.00/MMBtu and $4.25/MMBtu, respectively. His forecast for full year 2002 is $4.00/MMBtu.

If gas prices do not fall further, the demand drop-off could push October inventories well over the 3 Tcf mark, Driscoll said. Driscoll believes gas prices will range between the price of No. 2 oil (ceiling), and resid (floor) over the next several years. Given current oil and oil products prices that would put them between $5.25/MMBtu and $3.75/MMBtu. If prices go above No. 2 oil, he believes gas producers are threatened with demand losses of 4-5 Bcf/d.

In the near term, Lehman Bros. believes that gas prices will trade at residual fuel oil parity. "Natural gas prices are likely to fall to the level of low-sulfur residual fuel oil," Driscoll said. "At a price of roughly $3.75/MMBtu, we believe that gas would recapture 1.0-1.5 Bcf/d of demand from customers that are currently burning residual fuel oil, plus an additional 0.5-2.0 Bcf/d as a result of increased industrial demand and from decreased ethane rejection."

Driscoll also warned that further weakness in gas prices could cause E&P share prices to fall over the next 90 days. "We remain cautious on E&P shares," he said.

The bottom line SSB's Morris said "is we believe there could still be further downside for natural gas prices near term. Some firming is likely this summer with the onset of warmer temperatures across the country, although we do not believe a sharp and sustained run-up in prices is likely." Morris advised that the storage surplus will likely continue to expand until lost demand returns to level it out. Nonetheless, He said he expects storage to top 3 Tcf coming out of the summer.

Driscoll said injections into storage are currently 4.1 Bcf/d above historical averages. If injections stay on current course, storage levels could reach 3,400-3,500 Bcf by the end of October, which would be unprecedented. "We do not believe this will happen, as the maximum historical level is roughly 3,100 Bcf, and the seven-year average inventory level at the end of October has been estimated at 2,900 Bcf," Driscoll said. "We believe that the 'extra' 525 Bcf of gas versus the 2,900 Bcf historical average, will be sold to customers that have not been in the market...Demand should rise."

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