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Warm Weather Shaping 2007 Industry Outlook

In many places they often say if you don't like the weather, wait and it will change. From hurricanes to too-warm winters, weather has wreaked havoc on the gas industry in the last couple of years and it continues to dominate gas markets this season.

Although it steered clear of the Hurricane Katrina-induced $15.780 high from late 2005, the front-month gas futures contract in 2006 started at $11, hit a low of $4.070 on Sept. 27 and finished the year at $6.29. "The distinguishing factors of 2006 in the natural gas futures market were the hurricane season that never showed up and the winter that wasn't. It was basically the opposite of 2005," said Tom Saal of Commercial Brokerage Corp.

While the near-term forecast dominates the working lives of traders, it doesn't represent all of the weather that affects the industry. Thanks in part to the recent climate change in the halls of Congress, 2007 could well mark the ascendancy of global warming to top-of-mind status among consumers, politicians, regulators and industry executives.

There will never be 100% agreement that man's activities are drowning polar bears, but these days it seems as if everyone in the energy patch, or interested in it, has global warming factored into in his expectations.

"If we are undergoing rapid and sustained global warming, that means it never gets cold in the wintertime anymore; that's a real problem for us," Chesapeake Energy CEO Aubrey McClendon told NGI. "Yeah, the summers will be hotter, and that will partially offset it, but it's not a good trade for the natural gas producer to be looking at the temperatures we've had...If last winter and this winter are now the new norm, we've got at least a Tcf of gas too much in the system...To me that's the scariest thing."

When it comes to gas supply and whether long-term gas markets will be tight, it depends upon whom you ask.

Veteran industry analyst John Olson notes that the industry is drilling about 27,000 U.S. gas wells and another 16,000 in Canada just to run in place against ever steepening decline curves. And McClendon said, "I believe five years from now the Barnett [Shale] will likely be in steep decline and every other unconventional field that we're looking at today may be as well." But McClendon said he's sitting on a whole lot of gas in West Texas and elsewhere, the production of which just depends upon the right price.

And for now analysts at Wood Mackenzie told NGI that the firm has seen an unexpected turnaround in the domestic U.S. supply picture.

Shale Development & Costs

"We have made a real reassessment of the potential for the upstream market with the emergence of the new gas shale plays," said Jen Snyder, head of Wood Mackenzie's North American gas research group. "In the Barnett play, we're finding out that even as the producers are moving away from the 'sweet spot' [in the Fort Worth Basin], its potential has extended."

Tools used to develop the Barnett are being extended to other shale plays, such as the Woodford and Fayetteville. "We've turned around the [expected production] levels now based on that," continued Snyder. "Also, our expectations going forward are more robust than they were in 2005 after hurricanes Katrina and Rita. This has been a real positive development for the supply side."We've seen a real turnaround in domestic supply numbers, year-over-year," a turnaround, she said, which was not expected.

That's just as well, since imports from Canada could very well be a disappointment for the industry this year. During 2007 imports from Canada could drop by half a Bcf or more, Olson told NGI. Indeed, this year could be the beginning of the end of balancing supplies coming from Canada, which is using more gas for tar sands production and planning to burn more gas in power plants in Ontario.

It's all about costs. John Herold's Bob Gillon, who co-directs the consultant's equity research, said finding costs "might drop sharply if gas prices stay low and more producers curtail their investment outlays. The lag between reduced spending and changes in service costs is only a matter of months for land operations, somewhat longer offshore. Companies with 'resource play' projects will be the primary beneficiaries of lower service costs."

However, "the costs of doing business will continue to mount, slowly if prices remain level, and like a rocket if quotes move higher," said Gillon.

"Service costs caught up with everybody in 2006, but the level of growth goes on," energy consultant Stephen Smith told NGI. "In 2006, gas prices started the year at $9.50-10. That's historic for 2006. Throw it out, and look at March through October, it was more like $6.50, a lot like this year's going to look like.

"In 2007, the only difference is at $9-10. We are going to have a month where I think prices will drop down to $5.50 to $6; the glut will be as big as last year, with a discount of $1, $1.50; the middle part of the year will be the same.

"The places right now where it's difficult to drill for the price, such as Canada, will still find it difficult," Smith said. "With service costs, the whole industry is not drilling as many wells. But the impact doesn't happen instantaneously. There are downward pressures in places, and cutbacks right now.

"We've been in a situation where the demand for gas hasn't really grown in 12 years. And prices do what prices do. They serve as a rationing agent. There will be some changes this year, though. I spend a lot of time working on things about the weather. It's the most important variable. And the short-term forecasts have gotten incredibly good."

Climate & Consumers

Smith said the weather pattern "has gradually become clear that we've drifted into an El Nino pattern. And once you're in an El Nino, you're going to see more El Nino. That's a good bet."

But the warm weather and storage overhang come with a silver lining, at least for natural gas, at least in McClendon's view. "I think the industry needs to unite around the idea that concerns about global warming could be the best thing to happen to our industry in 20 years, if not 50 years, if we get out in front of the discussion and make it clear that the solution to global warming is to reduce consumption of coal and increase consumption of natural gas."

"We feel that climate change is going to be one of those issues that's going to dominate the nation's media and probably a lot of the legislative agenda in Congress," American Gas Association (AGA) President Dave Parker told NGI. "We think it will be beneficial to natural gas because people will start realizing how important natural gas is and how much cleaner natural gas is than all the other fossil fuels."

There's a new look to the demand side. Short- and long-term weather trends aren't just affecting the thinking of industry executives, they are weighing on the minds of consumers as well. The post-Katrina spikes in gas markets went a long way toward educating consumers about supply and demand in the energy industry. "I think consumers really recognized that the effects of the hurricane were reducing supply, and I think consumers really understood reduced supply meant increased prices," Don Mason, chairman of National Association of Regulatory Utility Commissioners (NARUC) gas committee, told NGI. A member of the Ohio Public Utility Commission, Mason said his office started seeing consumers reducing gas consumption well before the start of the heating season last year.

The first to experience the effects of better-educated consumers dialing down their thermostats are local distribution companies (LDC), who for years have watched throughputs on their systems decline with gas appliance efficiency gains and greater conservation by end-users. Many gas utilities have found revenue from volumetric service charges is no longer sufficient to cover their fixed costs and have sought to decouple distribution charges from consumption to preserve revenue as well as create incentives for encouraging more conservation.

AGA's Parker told NGI that the trade association launched an effort two years ago to promote rate decoupling. According to the AGA, 14 utilities in eight states serving 14 million customers -- nearly a quarter of all U.S. residential consumers -- now have rate designs that decouple distribution revenue from throughput volume. "We don't have a target per se, but we're working very closely with NARUC, and I would hope that we might see a doubling of the use of decoupling by the end of [2007]," Parker said.

So, high and volatile prices inspire conservation among consumers which in turn spawns a rethinking in rate design among utilities. Other structural changes taking hold at LDCs and indirectly brought about by weather include greater use of financial hedging and increased willingness to commit to longer term contracts that support upstream infrastructure, which facilitates greater gas supply diversity, noted NARUC's Mason.

The Looong Term

For the future, while liquefied natural gas (LNG) developed a hitch in its git-a-long this year, proponents are looking for it to be a contributor to the U.S. market in the future. "There's been a reversal in our outlook for North American LNG, which we weren't expecting," said Snyder. "We now have negative revisions on LNG expectations until around 2013."

Last year also saw a major setback to development of a gas pipeline from Alaska's North Slope (see NGI, Sept. 11, 2006). "We're back to square two on Alaska, not entirely square one," said Ed Kelly, Wood Mackenzie vice president of North American gas and power. "We're back to renegotiating the framework almost from the beginnings...There's a new, fresh political face [in recently elected Gov. Sarah Palin]."

Energy consultant Smith said he was unsure about the odds for an Alaskan gasline in the short- or long-term.

"I don't know. It's an interesting thing," said Smith. "It raises lots of interesting questions. To what degree should you assume that Alaska gas is more secure than a diverse LNG supply from around the world, and to what extent do you want to discourage having 2 Bcf in 2014 [which the pipeline could supply]. That's a lot of eggs in one basket. These are tough issues. To what extent should Washington [DC] be involved to add to fundamental market forces? If [the Alaska pipeline] is so viable, why does it need Washington's involvement?

Canada's Mackenzie Delta's gasline prospects continue to be a "matter of individual negotiations," said Kelly. "It may be a shorter process than Alaska, but it's still uncertain. It's still subject to delay. A more concrete process is under way in Alaska."

That's putting it politely. Smith is not optimistic that the Mackenzie Delta gasline will ever be built. "I'm so sick of hearing about the Mackenzie Delta I could scream...It's the world's most frustrating exercise to contemplate. Everyone's so worried about getting a piece of the pie, the pie never gets baked."

Olson said he thinks 2007 is starting "on a very weak note" because of soft commodity prices and weakness in producer share prices. Clearly, weather is keeping the industry down, for now. "I think we'll be pleasantly surprised by the end of the year as we work through this, what is turning out to be a two-year cycle, two-year plateau," Olson said.

And as somebody famous once said, "A lot is going to depend on the weather."

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