Significant downward pressure is expected to continue on the Henry Hub natural gas spot price as storage levels head toward a record high, more foreign supplies potentially make their way to U.S. markets and domestic production stays relatively flat despite a pullback in drilling, according to the Energy Information Administration’s (EIA) Short-Term Energy Outlook for August.

The spot price averaged $3.50/Mcf in July, 41 cents below the average spot price in June. “Prices remain low as the drop in drilling activity thus far has failed to bring about the producing decline necessary to slow the natural gas inventory build,” the EIA said in its outlook, which was released Tuesday.

“Resilient production [despite drilling cutbacks], high storage levels and the potential for increases in both LNG [liquefied natural gas] and pipeline natural gas imports suggest that prices may fall below current projections before space heating demand picks up this winter and economic conditions improve,” the agency said. It expects spot gas prices to average $3.92/Mcf this year and to rise to $5.48/Mcf in 2010 because of the “current decline in drilling activity and projected growth in consumption next year.” But it noted that “sustained cutbacks in drilling activity or stronger demand than expected could lead to even higher prices .”

Working natural gas in storage was 3,089 Bcf, 496 Bcf above the five-year average and 580 Bcf above the level during the same period in 2008. Working gas stocks eclipsed the 3,000 Bcf level on July 24. “This is the earliest day on record that inventories have exceeded 3,000 Bcf during the injection season (April through October),” the EIA said. The previous record was set on Aug. 31, 2007 when working gas stocks reached 3,005 Bcf.

“We now expect working natural gas stocks to reach 3,800 Bcf at the end of October, 235 Bcf above the previous record of 3,565 reported at the end of October 2007,” the agency said.

Although there has been a “significant pullback in drilling activities,” the EIA said it expects total domestic marketed natural gas production will stay flat at 58.65 Bcf/d this year and then decrease to 56.98 Bcf/d in 2010. “Data for March through May suggest that the decline in drilling has begun to reduce marketed production in the Lower 48, non-Gulf of Mexico [GOM] region. While the monthly average rate of decline was about 0.3 Bcf/d during those three months, production is expected to decrease at a faster pace through the remainder of [the year] with some curtailments from existing production expected.”

Meanwhile, the EIA sees federal GOM production increasing by 3.3% to 6.62 Bcf/d “in part because recovery from damage sustained during last year’s hurricane season and the lower incidence of hurricane activity this year.” U.S. drilling activity is likely to pick up early next year, but the lagged affect of reduced drilling this year is expected to lead to lower production in all regions outside of Alaska, the agency said.

While U.S. producers try to cut back production in response to low prices, the EIA said it expects more LNG imports from Europe and pipeline imports from Canada to be headed here. “With limited natural gas storage availability, recent data suggest that European inventory levels are now nearing capacity. As a result, LNG shipments may be redirected to U.S. ports in the coming months as prices in the European market become less attractive to LNG suppliers. A similar scenario may also occur in Canada, with natural gas pipeline imports increasing in the months ahead as Canadian storage facilities are topped off.”

The EIA projects LNG imports will increase to about 500 Bcf this year, up from 352 Bcf in 2008, and rise to about 740 Bcf in 2010.

On the demand side, the EIA expects natural gas consumption to slip 2.6% to 61.76 Bcf/d this year and rise by 0.5% in 2010. “Despite some recent signs of economic stability, the severe contractions during the first half of the year contributed to an estimated 3.8% decline in daily average natural gas consumption compared with consumption during the first half of 2008. The decline in natural gas use during this period was driven principally by a drop in industrial activity, reflected in the 17% year-over-year decline in the natural gas-weighted industrial production index during the first half of the year.”

Because gas prices have slipped to the point where they now compete against coal for a share of baseload power generation, “natural gas consumption in the electric power sector is expected to increase by 2%” to 18.56 Bcf/d this year, according to the EIA. This is more than the industrials’ share (16.52 Bcf/d) and residential customers’ share (13.04 Bcf/d).

“The assumption of improved economic conditions in 2010 is the primary factor leading to projected demand increases in the residential, commercial and industrial sectors next year. However the expectation of higher natural gas prices and lower coal prices in 2010 likely will lead to a slight reduction in natural gas consumption in the electric power sector,” the agency said.

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