A growing shortfall of natural gas will propel oil and gas services as the top Canadian growth sector through 2004, Bank of Montreal (BOM) economists reported Thursday. Meanwhile, Canadian-based Scotiabank Group’s latest commodity report index noted that declining U.S. natural gas deliverability should keep prices “strong” through next year.

“The Oil & Gas Index jumped by 15.5% in the month of January alone, with dramatically higher prices for light and heavy crude oil, natural gas and propane,” said Patricia M. Mohr, vice president of Scotiabank’s economics industry and commodity market research. “Energy prices are currently 87.6 % above a year ago — propelled by ongoing geopolitical tensions, frigid winter weather especially in the U.S. Northeast and Midwest, and declining stocks.”

Mohr noted that current “war premium” prices would likely fade over the next six to 12 months, but that a “fundamentally tight North American supply/demand picture is expected to keep natural gas prices strong for some time. Despite high prices and last year’s decline in deliverability, U.S. gas-targeted drilling activity has only picked up marginally in early 2003 (up 4.6% over a year ago).”

In Canada, “the response has been better, with a 23% year-over-year gain in both oil and gas drilling (mostly geared toward natural gas),” Mohr said. “This may reflect better exploration and development prospects in Canada and an increased aversion to risk in the United States, given the energy-trading scandals and skittishness of U.S. equity investors in recent years.”

In the BOM commodity outlook report on prospects for Canada’s industries, economists predicted that the key industrial drivers through 2004 will be led by the “looming shortfall of natural gas,” which will “bolster exploration and development activity.” In fact, oil and gas services led the picks for Canada’s “fastest five sectors in 2003-2004.”

“In the United States, rapid production declines in conventional wells have not been fully offset by gains in the deepwater Gulf,” said BOM economists. “Output in Canada also weakened in 2002 due to fast decline rates in the conventional basin. Despite rising and high prices, drilling activity dropped off sharply as companies focused on restoring balance sheet health. Additionally, there has been some skepticism that high prices would be maintained.”

While “producers are beginning to accelerate drilling, the lag in getting new gas to market, combined with increasing demand for industrial use and power generation, suggests a tough struggle to rebuild inventories to adequate levels prior to the winter of 2003-2004,” noted the economists. “Thus, the price of the U.S. benchmark, Henry Hub, is projected to rise to an average of US$4.10/MMBtu in 2003 from barely over US$3.00 in 2002. This would mean a price in Western Canada of US$3.70/MMBtu.”

In the medium to long term, BOM economists forecast that gas prices will remain high, “actually rising about 1% per year in inflation-adjusted terms — to justify the economics of new investments in liquefied natural gas (LNG) and the construction of pipeline connections to Arctic supplies.” For the next two years, some of Canada’s sectors will falter, but not energy.

“Sectors such as Oil & Gas Services and Agriculture are projected to achieve high growth rates, largely reflecting rebounds from sharp declines during 2002,” said the economists. “In the case of Oil & Gas Services, the looming shortage of natural gas in North America, the trend toward higher prices, and the improved financial condition of firms in that sector should stimulate a sharp recovery in exploration and development activity.”

Also, “output related to actual Oil & Gas Extraction is projected to continue to grow at a relatively sluggish pace, reflecting declining productivity of wells in the Western Canada Sedimentary Basin (WCSB) and little new offshore supply coming from the East Coast during the next two years.

In BOM’s forecast for the oil and gas sector, economists noted that “fairly sharp declines in production of conventional light crude in Alberta during the past couple of years reflect declining resources in the WCSB and a pull-back in drilling activity.”

The drilling cutbacks were from several factors, noted BOM. “First, majors have been refocusing their exploration and development activity offshore and have place an increased priority on balance sheet repair. Second, the intermediate territory has increasingly been taken over by income trusts, which focus on exploitation of existing resources rather than on exploration. Third, until the fourth quarter of 2002, producers were concerned that excess OPEC production and rising output from Russia would eventually cause prices to collapse.”

And more recently, they noted, “the rising likelihood of a military confrontation with Iraq and the devastating impact of the general strike in Venezuela on its oil output have caused North American inventories to drop to quarter-century lows and prices to push close to US$35/bbl for the U.S. benchmark, West Texas Intermediate. Despite this, producers are likely to remain cautious. There remains concern that, in the face of substantially increased OPEC production, resolution of the Iraq issue and the usual decline in demand during the spring could cause prices to fall sharply.”

Output gains along Canada’s East Coast are unlikely to offset the WCSB declines, said BOM. “Now that Hibernia is operating close to its normal capacity and Terra Nova has been online for about a year, output gains on the East Coast are unlikely to provide as strong an offset to declines in the WCSB as they did in 2002.”

Natural gas producers also “will be hard-pressed to raise output during the next couple of years,” the economists said. “Production growth has been on a declining trend, with virtually no increase in 2002. This reflects a sharp drop in drilling activity in the latter part of 2001 and 2002 (down about 30%), falling productivity (initial output per day) in newly connected wells in the WCSB, and increasing decline rates (the rate at which productivity decreases from its initial levels).”

But BOM noted that the flat production trend actually started before 2002. “Although output increased a little over 2% in 2001, that reflected new gas from both the Sable Island Offshore Project (which commenced in 2001 and is now producing about 500 MMcf/d) and from Ladyfern in British Columbia. With little new gas coming from offshore Nova Scotia during the next two years and with rapid production declines at Ladyfern and other parts of the WCSB, Canadian producers will face a tough struggle to just maintain total output during 2003 and 2004.

“Given similar supply problems in the United States and the upward trend in demand, the likelihood of flat output in Canada will contribute to high natural gas prices during the next few years,” BOM noted.

Down the road, however, BOM economists believe there will be a “renewed growth” in natural gas production. “Drilling activity is already being stimulated by the growing realization that high prices are probably here to stay and by the improving financial condition of producers. Further, there will likely be an increased focus on deeper drilling in the WCSB in order to connect wells with higher productivity levels and reserves. This, combined with initial production from the second phase of Sable Island (likely coming on-stream in 2004 and ramping higher by 2005) should lead to higher overall production rates in Canada during the 2005-2007 interval.”

Even with gas production increases, however, “the likelihood of power-generated increases in the North American demand for gas over the longer term points to a rising reliance on imports of LNG and the development of northern frontier resources. The economics of investments in LNG import capacity and in building pipelines to frontier regions will require prices in the neighborhood of US$4.00/MMBtu and higher.”

Although increases in other mineral fuel extraction are likely to proceed at a sluggish pace of less than 2% a year over the next two years, BOM economists were more optimistic about oil and gas, predicting service company output to jump sharply.

“We anticipate output growth for this industry to average 11.4%, reflecting a rebound in drilling activity related to both exploration and development/maintenance of existing wells. There is also likely to be a refocusing of natural gas drilling activity to more expensive, deeper resources. Further, oil sands development is continuing at a fast pace, requiring substantial participation from independent servicing companies.”

To access the entire Canadian outlook report by BOM, visit the web site at www.bmo.com/economic/regular/sector.html.

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