Only a much colder than normal winter would stop gas prices from falling below $4 in the next few months, according to consultant Stephen Smith, who sees a significant supply surplus built into the market because of lasting demand destruction and new supply from non-traditional resources.

In the September Monthly Energy Outlook from Stephen Smith Energy Associates, Smith noted that the supply surplus began to show up in the much higher than expected gas storage injections in May and June when $5.50-$6.25/MMBtu gas prices caused a significant amount of demand destruction. Smith calculates there were weather-normalized weekly gas storage surpluses of about 30-37 Bcf in those months. Then with the drop in prices to $4.70-$5.10 in mid-July to mid-August, the weather normalized storage surplus declined to about 5-10 Bcf/week.

“The fact that weather normalized weekly surpluses did not return to zero when prices moved below $5 was an early warning sign that a surprisingly durable surplus had been created,” Smith said. “In the last six weeks, with gas prices mainly in the $4.50-$5.10 range, the weather normalized surplus trended upward again back to the 30-35 Bcf/week range.

“So now we are experiencing substantial demand destruction and/or supply creation with prices about $1 lower than the May/June episode. This should not be comforting to producers. It suggests the possibility that some irreversible (or hard to reverse) components to the demand destruction and/or supply creation have occurred.”

Smith noted that while gas prices have fallen about 15% over the last 10 weeks, East Coast residual fuel oil prices have as well, making it difficult for gas to regain any industrial/utility market share.

Smith suggests that production decline rates in traditional domestic supply basins have slowed because of stronger drilling. They also have been offset somewhat by non-traditional supply sources, such as LNG imports and deepwater production (Pioneer’s Canyon Express) that has come on line.

While Smith remains relatively bullish on gas prices over the long term, he cut his “equilibrium” price expectations for the 2004-2006 period by 50 cents to $3.50-$5.50.

“We expect to test the lower end of this price range if the coming winter is normal or mild,” Smith said. “We are lowering our 4Q2003 gas price estimate from $4.50 to $4.25 and expect a bottom in the $3.50-$4.00 range in the next few months as lower gas prices regain market share and dampen LNG imports.”

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