Financial market fundamentals and some tightening in the supply-demand balance for natural gas in the first half of 2008 were responsible for the roller-coaster ride for gas prices last year, according to a report released by FERC last Thursday.

“The rise in natural gas prices coincided with a global increase in many commodity prices. This increase in commodity prices occurred as large pools of capital flowed into various financial instruments that essentially [turned] commodities like natural gas into investment vehicles. Ultimately, we believe the financial fundamentals along with the modest tightening in the supply and demand balance for gas during the first part of 2008 explains natural gas prices during the year,” Arnie Quinn, who helped prepare the “2008 State of the Markets” report, told the Federal Energy Regulatory Commission (FERC) at its monthly meeting.

“We believe physical fundamentals alone cannot explain [the high] natural gas prices experienced during the first half of the year,” said Quinn, director of FERC’s division of Energy Market Oversight. Gas prices last year were “substantially greater” than prices in 2007, with the average gas price ranging between 16% and 29% more — with a few exceptions, according to the FERC report. “Average natural gas prices at Cheyenne [WY] were 54% higher than 2007 due to increased pipeline infrastructure out of the Rockies that allowed gas frequently bottled up in 2007 to flow to higher-priced markets” in the Midwest.

Questioned by commissioners as to whether natural gas prices again could be affected by commodity market gyrations, FERC staff said it was seeing “the very beginnings of the potential that commodities again are becoming an attractive investment vehicle. There is not an influx of capital yet; it is more an enthusiasm.” As to the implication for consumers: in 2008 it was very difficult to figure out when to buy because it was impossible to tell what was driving the market. “Right now, consumers have the same problem.”

For the most part, natural gas supply and demand remained in balance in 2008, according to the FERC report. “There were no major disruptions to supply during the first half of 2008 that would explain the increase in prices. Total gas supply, including domestic production, pipeline imports and LNG [liquefied natural gas] imports, was up 3% through June of 2008 relative to the same time period in 2007. In September, hurricanes Gustav and Ike did cause a considerable drop in supply availability — more than 10 Bcf/d. This drop, however, occurred after gas prices began their precipitous late-summer decline, briefly interrupting but not ending the prices’ downward trajectory.”

At the same time, gas use through June 2008 increased 3.6% relative to 2007, primarily because gas demand in January and March was higher than 2007 and 2007, according to the report.

Nor was the level of natural gas in storage a significant factor in the price fluctuations last year, the agency report said. “While physical market fundamentals, particularly storage levels, can explain why natural gas prices rose during the first six months of 2008, none of the market fundamentals were extreme enough to explain why Henry Hub prices reached [a high of] $13.31/Mcf” last year, it noted.

Gas prices rose during the summer of 2008 to levels “never before experienced during any previous summer in the United States,” the report said. Henry Hub spot prices peaked at $13.31/Mcf on July 3 and then fell to $5.71/Mcf by year-end 2008.

“Today natural gas prices are below $4/MMBtu. The physical factors that drove prices in Q4 2008 and Q1 [this year] have the potential to fundamentally change the natural gas markets over the next few years. In short, natural gas is not scarce. Going forward, a key consideration is whether the natural gas production will be able to get into balance with consumption in a manner that will not lead to an exaggerated boom-bust cycle.”

Most of the domestic production growth has been concentrated in unconventional gas fields — tight sands, coalbed methane and shale formations. In 2008, unconventional gas production represented 51% of total gas production and grew 14%, while conventional production fell 3% during the same year, FERC said.

The agency estimated that break-even prices for unconventional gas producers range from a low of $3.30-5/MMBtu to a high of $5-7/MMBtu. However, prices at the end of the first quarter this year were “somewhat below” the level needed to sustain drilling activity in most unconventional basins. “This is borne out by the dramatic plunge in the gas rig count during the fourth quarter of 2008, from a peak of over 1,600 in early September to less than 900 currently. If sustained, the slowdown in drilling will likely lead to much lower production growth or even production declines, which could in turn lead to much higher prices when industrial gas demand rebounds,” the report said.

The Commission said more than 20 producers announced in the latter part of 2008 their intention to reduce capital expenditures by more than $22 billion. “Some of the planned reductions are almost certainly related to the fall in natural gas prices and the desire to rebalance supply and demand. Nonetheless, some of these announcements are also likely related to reduced access to capital and the increased cost of capital.”

In its market review of 2008, FERC identified a number of “discrete issues that put upward pressure on prices” in the first half of the year, including:

On the flip side, the Commission report cited several factors that contributed to the lower prices in the second half of 2008, including:

By the end of 2009 new production and infrastructure projects are “poised to transform the natural gas markets in the major consuming regions. Chief among these projects is the Rockies Express [pipeline],” FERC said. It noted that LNG imports are another potential short- and medium-term driver. The United States received less than 1 Bcf/d of imports last year as prices in the rest of the LNG-importing world were higher than U.S. prices, but some analysts foresee U.S. imports rising to more than 3 Bcf/d by the third quarter. “A large inflow of LNG could put substantial downward pressure on natural gas prices, especially if U.S. demand does not rebound or production growth does not slow.”

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