Caution Ahead for Natural Gas

Punxsutawney Phil may have forecast six more weeks of winter, but it won't be enough to seriously dent underground gas storage. Rising natural gas production and greater investment in the oilpatch signal a potential slowdown in the 2nd half of 2004.

Is there a groundhog day for gas storage?

Now would be a good time for the mystical rodent to provide his forecast. With winter withdrawal season down to the last 60 days, a quick look at gas storage arithmetic indicates some drama is on tap in the natural gas markets.

And that will be despite the announcement this Thursday of one of the larger draws on natural gas storage in the last 10 years. Early estimates are that the U.S. could see 225 billion cubic feet withdrawn from storage, or about 10 percent of the total estimated draw for the entire winter, when the Department of Energy reports its weekly numbers on Thursday.

It's been cold in groundhog land--and many other gas-consuming areas of the country as well. Still, the storage numbers indicate the U.S. will exit winter with 1 trillion cubic feet--or more--in the ground, which would be right at the five-year average. "Average" is a funny term in this case, since it includes a low of 642 billion cubic feet last year and a high of 1.49 trillion cubic feet in 2002.

Despite cold weather, snowstorms, and Punxsutawney Phil, the industry is likely to exit winter with as much as 400 billion cubic feet more gas in the ground than last year. And that will likely reverse the market psychology the industry experienced last year.

Last year, market psychology evolved into occasional panic. There were expectations that the U.S. would be unable to meet wintertime storage needs, plus supply the spot market, over the summer. And in June, those concerns became part of the national news when Alan Greenspan talked somberly about chronic tightness in North American natural gas markets.

Meanwhile storage injections were behind the curve all summer and it looked as though there was no way those levels would get the industry to a secure situation in time for the winter of 2003/2004. Then it was discovered late in the summer that the DOE's sampling methodology was understating the amount of gas moving into storage. The gas storage estimate is announced each Thursday. What looked as though it was a potential crisis all summer long was rather a demonstration of competence and success by the underdog oil and gas industry.

The most important "take away" from last summer's market gyrations is the fact that the weekly gas storage number had evolved into a proxy for the natural gas business, even though wintertime storage accounts for less than 17 percent of natural gas use.

And that played into two important factors creating the background noise that has clouded perceptions of the natural gas situation.

The first factor is speculative hedging. Speculative interests now play a greater role in the energy commodities market. The term "speculative interests" simply implies those buying futures contracts who have no direct interest in ever taking delivery of natural gas. It is merely a financial instrument, or a bet on which way the market is headed. The speculative element was a major factor in October's brief gas price spike. The market had grown imbalanced with a majority of speculative interests expecting gas prices to fall on news that storage had filled at a greater rate than expected. A quick bump in oil prices in October upset the traditional gas/oil financial ratio, and the markets turned on those who were holding short positions, in a virtual feeding frenzy.

This speculative element creates uncertainty and encourages greater short-term volatility. As the industry grows closer to the start of injection season, average or above average levels of natural gas storage could have a negative impact on natural gas prices because of the market moves of this speculative element.

The second item is natural gas production. Raise your hand if you're confused on this one. You have the big financial houses doing studies of the nation's 20, 30, or 50 largest gas producers. These studies invariably show gas production is headed down, both year-over-year and sequentially. It is an idea reinforced in the headlines. Both ChevronTexaco and ExxonMobil noted declines in North American gas production during their 4th quarter earnings releases.

On the other hand, the U.S. DOE is reporting in its Natural Gas Monthly that U.S. natural gas production is rising. That rise is about two percent for the year-to-date through the 3rd quarter versus the three percent decline for 2003 commonly cited among members of the financial industry.

Who is right--big financial houses or the DOE?

They both are. There is little doubt some of the largest producers are witnessing continuing decline in gas production. These are the entities that the financial industry monitors. Some of that decline is because the majors are reinvesting 40 percent or less of their North American cash flow back into North American field work. Essentially these companies are monetizing North American reserves and investing the capital overseas--in some cases in LNG infrastructure that will eventually bring foreign gas to compete with U.S. production.

But this sampling of gas producers may represent shrinking market share, which is why the DOE numbers are different than those of the financial industry. Basically, the top 20, 30, or 50 gas producers are losing market share to dozens of smaller E&P firms. Earnings announcements of the smaller firms that are publicly held are often relegated to the back pages of the trade publications, if they are mentioned at all. Still, this group is reporting gas production headed up--sometimes spectacularly so. Pioneer Natural Resources has seen gas production more than double. XTO Energy Inc. is up more than 25 percent.

Even without such results, the news is invariably positive for a growing host of smaller E&P firms--many of whom are now able to raise outside capital to further expand 2004 drilling programs. The aggregate production of this segment apparently is more than enough to offset the decline among the sample of the nation's largest gas producers, which explains the difference between financial industry numbers and those contained in DOE reports.

What are the implications? Rising production, greater investment, and storage that will be close to average suggests that the challenge in late 2004 will be trying to manage too much production.

Barring unexpected outside influences, industry activity levels--and commodity prices--may be lower later this year than they are currently.