'Conservation Conflict' in Alberta Will Crank Up Gas Prices

Abstract: A regulatory fight in Alberta, involving gas producers on one side and bitumen developers on the other, is one more variable increasing upward pressure on gas prices this summer, and perhaps has implications elsewhere.

Analysis: "Conservation conflict" sounds like a phrase to describe opponents fighting about drilling offshore California, but the term refers to a regulatory battle in Alberta that will contribute to strong North American natural gas prices all summer and fall.

The Alberta Energy Utilities Board (EUB), the province's energy watchdog, stunned many in the Canadian oilpatch by proposing that as of Aug. 1, 2003, they would shut in about 900 northern gas wells to protect bitumen reserves underneath. Bitumen, a tar-like heavy oil, is extracted from Alberta's massive oilsands deposits and can be upgraded into synthetic crude.

The issue of bitumen production versus gas output is not new in Alberta. Gulf Canada Resources, now part of ConocoPhillips, complained in 1996 that gas production from wells near Fort McMurray would reduce pressure and recoveries from its Surmont heavy oil project. After a lot of wrangling, the EUB decided to prohibit new wells and grandfathered 146 holes drilled before 1998.

The EUB, an independent agency whose top officials are directly appointed by the Alberta government, decided to change the policy after concluding the grandfathered wells present "an unacceptable risk to future thermal bitumen recovery."

The freeze applies to 5.5 million acres located in the remote marshes and forests of northeastern Alberta. The EUB estimates the area contains 100 billion barrels of recoverable bitumen reserves. These reserves are seven times greater than all conventional oil produced to date in the province and 60 times bigger than remaining conventional oil reserves, the board said.

The ban would block producers from going after an estimated 1 trillion cubic feet (tcf) of gas reserves, about two percent of the province's remaining total. On an energy equivalency basis, the gas in the Wabiskaw and McMurray formations equals 175 million barrels of bitumen. (It is proposed that gas in other zones in the region will still be allowed to be developed.)

Industry players were asked to comment on the issue, and the submissions showed a clear split among producers.

A number of large firms, all with bitumen ambitions, supported the EUB's position. Firms such as Nexen Inc., Petro-Canada, and Imperial Oil Ltd. (a subsidiary of ExxonMobil) said it makes sense to protect the oilsands. The unconventional oil source has enjoyed a multibillion-dollar boom over the past five years.

Some heavyweights took the opposite tack. Companies such as BP Canada Energy, Canadian Natural Resources, and Talisman Energy opposed the impending shutdown.

But the decision, released earlier this week, clearly shocked some oilpatch executives.

The board's proposal was called "dictatorial" and "oppressive" by Paramount Energy Trust, strong language for what is normally a friendly relationship between the industry and its major regulator.

The outspoken comments reflect the big hit the decision could have on Paramount's bottom line. Up to 44 million cubic feet per day (mmcf/d), about 50 percent of Paramount's daily gas production, could be shut in as a result of the EUB's action. The negative potential caused investors to exit the stock like worried conventioneers fleeing Toronto after another SARS outbreak, hacking off about one-third of the trust's market capitalization in a single day.

The proposal (called General Bulletin 2003-16 and available under the "News" section at www.eub.gov.ab.ca, at the "What's New" heading) has not yet been finalized. The board intends to hold a meeting in early July to gather comment on its proposal. There's no doubt that some pretty scathing remarks are going to be made if this week's reaction is anything to go by.

While Paramount and others are deeply unhappy about the impending proposed changes, part of the EUB's legal mandate is to adopt conservation measures that maximize the recovery of hydrocarbons and economic benefits to the province. Given that the energy content of the bitumen is 600 times greater than the gas, the new rules fit the EUB's enabling legislation.

Producers will certainly argue for compensation, an issue that Alberta politicians are trying to duck by saying it's too early to take a position. However, petroleum firms don't have much of a foundation to build a legal challenge upon since the board is merely exercising authority granted by the provincial government, which, under Canada's Constitution, has responsibility for the province's energy and minerals.

The proposal would shut in about 250 mmcf/d of Alberta's daily output, roughly 2 percent of its total of nearly 12.5 bcf/d.

Normally removing 250 mmcf/d from supply would not be a big deal, especially considering that U.S. demand is expected to average around 52.5 bcf/d this summer. But these are not normal times, evidenced by U.S. Secretary of Energy Spencer Abraham recently asking his advisors--the National Petroleum Council--to hold a special meeting to identify short-term ways to ease supply constraints. The EUB's proposed move will not make the council's job any easier when members meet on June 26.

Gas prices last winter peaked at around $12 per million British thermal units (mmBtu), close to four times the average of the past five years. The peak was hit even though U.S. storage facilities entered the season with record inventories of 3.2 tcf, so imagine how they high will go this winter if storage levels only get to 2.7 to 2.8 tcf.

The most recent report from the Energy Information Administration showed U.S. storage operators pumped 114 bcf into their facilities last week. Despite the higher-than-normal injections, gas stocks of 1.2 tcf remain below the five-year historical range.

In addition to depleted storage, early forecasts predict another hot summer. While unlikely to match last year's scorching temperatures, the third-warmest summer on record according to the U.S. National Oceanographic and Atmospheric Administration data, the dog days of July and August will add upward pressure to gas prices.

The Natural Gas Supply Association, which recently released its first summer outlook, also noted low water levels in California and the Pacific Northwest are going to boost demand for gas-fired electricity.

The weather, obviously, will largely determine how much effect the EUB's decision to remove 250 mmcf/d has on North American gas prices. If it's a hot summer and storage levels remain low, then producers who didn't hedge are going to be laughing all the way to the bank.

The EUB proposal also highlights the vulnerability of income trusts, market darlings of the past couple of years, to factors outside of their control, including interest rates and commodity prices. Investors who forget that there are risks attached to these investment vehicles could be in for a rude awakening.

Correction: In the headline and body of the June 4 edition of Oil & Gas Advisory, we misspelled "Alfred E. Neuman." It should be "Alfred E. Newman."