Consultants at Massachusetts-based Energy Security Analysis Inc. (ESAI) said last week that they believe many industry analysts and the large number of new financial players in the gas futures market are underestimating the impact of rising liquefied natural gas (LNG) imports and could be in for quite a surprise near the end of the storage injection season.

Rival consulting firm Energy and Environmental Analysis Inc. (EEA), based in Arlington, VA, last week expressed what many in the industry and the federal government have been preaching for months now: that gas prices are likely to continue rising because of tight productive capacity and growing demand due to the recovering economy. EEA said prices are likely to average $6.10 at the Henry Hub this year and catapult over the $7 mark in 2005 with potential spikes to $9.50 this winter.

Despite adequate storage injections and average working gas levels, EEA expects prices for the rest of the injection season to average $6.45 at the Henry Hub. And the federal government is preaching the same party line. The Department of Energy’s Energy Information Administration (EIA) currently expects Henry Hub prices to average $6.30 for all of 2004, $6.64 in the fourth quarter and $6.59 in the first quarter of 2005 because of the tight supply-demand balance.

Both EEA and EIA agree that the supply-demand balance has shown no significant signs of change. With the economy expected to continue growing, demand from residential and commercial sectors is bound to increase slowly, while production, even with a significant drilling effort, is barely rising.

Furthermore, In its latest Monthly Gas Update, EEA estimates that demand from the power generation sector will be up 12% this year to 13.5 Bcf/d and will grow another 1 Bcf/d next year. Meanwhile, domestic gas productive capacity remains flat, EEA said.

“U.S. domestic production will be hard pressed to reach 2001 levels anytime soon,” EEA said last week. The consulting firm expects production to rise slightly this year, while gas imports will be hindered by tight world LNG supply, limited LNG import capacity and production difficulties in Canada that are similar to those in the United States.

Not so fast, said Scott DePasquale of ESAI. Few seem to realize that LNG imports jumped to 150 Bcf in the first quarter of this year from only 75 Bcf in 1Q2003. For the second quarter of 2004, ESAI expects LNG imports to total 205 Bcf. And for the year LNG imports are expected to total 800 Bcf compared to only 506 Bcf in 2003.

While many observers have pointed to the limitations on LNG import capacity, they apparently are unaware that import capacity utilization was only at 50% last year. It’s approaching 80% at some terminals currently. With expansions taking place at Cove Point, MD, and Lake Charles, even more capacity will be available prior to the addition of any new terminals. And at least one new terminal, the Excelerate Energy Bridge offshore Louisiana, is expected to be operational this winter and bringing in additional LNG sometime next year.

“As we warned in our last quarterly report, LNG imports are starting to materially impact the cash markets in both the Gulf and Northeast regions, acting as a catalyst to regional storage injections, and helping to dampen the impact of price pressures on the Nymex,” said DePasquale, a senior analyst at ESAI. “We expect that trend to continue for the next three years.”

As a result mainly of rising LNG imports, ESAI is forecasting that gas prices will start to fall near the end of the injection season and will remain below $6 on average through 2014 — with the potential for winter price spikes above $6.

“While we are closely monitoring the decreasing rig efficiencies and increasing supply cost structures, demand growth will be low to moderate at best until 2008, allowing new sources of supply to effectively re-balance the market over the near-term,” DePasquale said, also noting that domestic production should rise temporarily due to drilling increases.

ESAI believes that slightly rising production, moderate demand growth and rapidly rising LNG imports will cause significant downside price pressure over the next few years — bringing natural gas for delivery at the Henry Hub to an average yearly low of $4.29/MMBtu in 2008.

Just when the tide will turn, however, depends in part on the reaction of market players, and that has been hard to measure lately because of changes in the composition of futures market.

Futures traders on the New York Mercantile Exchange pushed gas prices back over $6/MMBtu last Thursday in what many considered an overreaction to a slightly lower than expected storage injection number.

There is a growing number of non-commercial players — speculators without a physical presence in the gas market — in the gas futures pit these days. Their unfamiliarity with market fundamentals, inadequate view of supply and different trading methods have contributed to the increasing volatility of the gas futures market and the current high gas prices, said DePasquale.

“The first reason [prices are so high], I would suggest, is the increase in open interest in natural gas [futures] by non-commercials,” he said in an interview with NGI. “In the late 1990s and early 2000s, open interest by hedge funds and non commercial players never breached 12-13%. If you looked at it a few weeks ago, open interest [by non commercials] peaked — when we had that second spike above $6.50 — to roughly 32%.

“It’s huge, I assure you. They’ve actually been sustaining levels of open interest above 25% since just after March.”

The entrance of a more speculative element in the market has more closely linked natural gas to the crude oil and petroleum products markets because the financial players trade gas in a basket with the other energy commodities, according to DePasquale. “I think that has a lot to do with why we are sustaining higher prices, but it’s not [the entire reason].”

Financial players don’t have a clear understanding of the current and future gas supply situation. That’s partly their own fault, but it’s also the fault of industry companies, regulators and the federal government. There’s a dearth of timely supply information available. What is available is several months old or provides an incomplete picture of the total supply situation. There also have been reserves accounting errors which has led to even more confusion about future supply.

But the financial players should be getting more of the message about growing supply relatively soon, said DePasquale. “They will start to see larger deviations between the futures market and the actual cash prices at the various hubs,” he said. “When cash stops reacting to the Nymex and it becomes very competitive to try and dump all this [LNG] supply into the market in the Gulf, you will start to see the futures come in line with cash.”

However, the cash market has been extremely dependent on the futures market since the departure of large groups of physical traders from Enron, Aquila, Dynegy, El Paso, Williams and numerous other companies that have closed up their trading shops. Today’s cash players are mainly price takers rather than price makers. They are slaves to the Nymex screen and it will take a significant turn of events to change that.

“Williams and Enron, who really understood the cash markets, are no longer in the game, so folks have been taking cash prices that they may not have taken in other periods,” said DePasquale. “But I can assure you, as production becomes more robust toward September and we don’t have as much of a need to put gas into storage because storage levels are already full and the LNG imports are coming in, if you are a cash trader and everybody is calling you to buy gas, you aren’t going to care anymore about the Nymex.

“It’s not going to happen until storage is almost full.” But that could end up taking place a month early this year, he said.

However, ESAI also warned that finding and development challenges are likely to catch up with the market by late 2005, at which time ESAI expects a significant lull in U.S. dry gas production. “In fact, we warn that over the long-term, domestic resources will continue to diminish, increasing the costs associated with finding and development, and increasing the need to rely more heavily on LNG imports to fill the gap in a cost effective manner,” DePasquale said.

Nevertheless, the Boston based energy research firm remains confident that further investments in the domestic LNG infrastructure, if permitted, will indeed help to keep prices under control.

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