Meridian re: the Nat Gas debate...
July 13, 2001
Wholesale Natural-Gas Prices Are Falling,
But How Will Long the Drop Last?
And What Impact Will It Have on E&P Companies?
By Will McNamara
Director, Electric Industry Analysis
[News item from Natural Gas Intelligence]
Although certain pockets of the country that use large amounts of gas for power generation may see some increase in natural-gas prices over the next couple of months, the chance of any significant summer jump in gas prices now seems remote, according to a new Energy Information Administration (EIA) report. With natural-gas storage injections hitting record highs in April through June, the agency sees average wellhead prices in the third quarter continuing on a downward slope, averaging $3.40/Mcf. In its Short-Term Energy Outlook for July issued last week, the EIA also noted that spot gas prices have fallen about $1 per MMBtu to near $3 since mid-June.
Analysis: The fact that natural-gas prices have dropped to (and are expected to stay at) the $3.40/MMBtu range is significant, considering that we haven't seen these levels for almost a year. In fact, at certain times over the last 12 months, some projections had indicated that the high prices would remain intact through 2003. Recall the spikes of December 2000 and January 2001, which sent natural-gas spot prices to levels between $20/MMBtu and $30/MMBtu in some regions. Thus, the fact that prices have now fallen to levels within the $3.00/MMBtu range, moving toward levels of 1999 and before, is a truly notable development. What everyone wants to know at this point is how long the drop in gas prices will last, and also what impact it will have on those companies that are directly involved in exploration and production (E&P) activities. Of course, there is no clear answer to the first question as a sudden change in weather conditions could send natural-gas prices through the roof once again (although that now appears unlikely due to other factors). While most analysts have joined in on the consensus that natural-gas prices will stay relatively low through the third and fourth quarters of this year, what is perhaps a more interesting question is how the drop in prices may change the competitive direction for the leading natural-gas production companies, as well as those companies which are primarily focused on power but have significant natural-gas exposure.
First, let's look at some of the available data from other sources to confirm the projections from the EIA, and establish the reasons for the drop in natural-gas prices. Energy and Environmental Analysis, Inc. (EEA) shares the EIA's projection that natural-gas prices will remain in the $3.00/MMBtu to $3.28/MMBtu range for the remainder of the 2001 gas storage injection season. Although prices may jump up again this winter (possibly averaging around $4.30/MMBtu), EEA says that, as domestic supply continues to strengthen, prices should drop below $3/MMBtu on a consistent level moving forward. In addition, investment firms such as Salomon Smith Barney, Lehman Brothers and Simmons & Co. recently forecast that average spot targets for 2002 will range between $3/MMBtu and $3.75/MMBtu, compared to previous estimates of between $3.75/MMBtu and $4.20/MMBtu.
Merrill Lynch has maintained its forecast of spot prices in the $4.25/MMBtu range, and is somewhat of a dissenting voice among the general consensus that gas prices will stay low. Merrill Lynch in fact remains comfortable with its Henry Hub projection of approximately $5.15/MMBtu in 2001 and approximately $4.38/MMBtu in 2002, believing that fuel-switching economics will favor gas primarily for the first time in the next 12 months, which will increase demand and prices.
Despite this debate over price trends for the next 12 months, we know that the first six months of 2001 have brought a dramatic drop in prices. The decrease has seemingly resulted from four different factors, which I'll discuss briefly.
The weather has been comparatively mild. Weather is the most important factor that has caused the drop in natural-gas prices. Generally speaking, throughout much of the country, spring brought comparatively mild temperatures, which in some places has continued into summer. Granted, today is July 13, and there are still about six weeks left of summer temperatures. As such, a dramatic increase in temperatures could cause natural-gas prices to skyrocket once again (despite the fact that most observers of the gas market doubt that this will occur). However, we do know what has occurred up to this point, and for the most part temperatures have been comparatively cooler. This is a trend that is continuing. Cooler temperatures have meant reduced use of air conditioners in many parts of the country. As natural gas now is being used to fuel a large number of electric power generators, the mild-temperature trend has contributed to lower prices. For instance, in Texas (where about half of the power generation on ERCOT comes from natural gas), temperatures had not broken 100 degrees as of July 1 and in fact had stayed in the high 80s and low 90s for most of May and June (atypical for the region). As a result, spot market prices in the state had dropped to $3.30/MMBtu on July 9. On NYMEX, the August Hub natgas contract was trading at $3.29/MMBtu on July 10. Also, in the West, unusually cool weather caused natural-gas prices to hit $3.46/MMBtu and below at the hub of Sumas, Washington County in late June, considerably down from an unprecedented high of $14.20/MMBtu in January.
Demand for natural gas has dropped significantly. The second factor is a significant drop in end-user and utility / industrial demand for natural gas. High prices that were common through the early part of 2001 sparked increased conservation levels on the part of end users and caused many electric utilities that traditionally used natural gas to seek out other fuel sources, such as coal. In fact, electric utility demand for natural gas reportedly has fallen by an average of 8.3 percent in the first six months of this year. Power consumption is reportedly down about 6.5 percent in California. In addition, as prices continued to rise, many industrial plants reduced their production levels or even shut down temporarily to avoid paying high power costs. In the Pacific Northwest, for instance, many aluminum companies have engaged in contracts with large providers such as the Bonneville Power Administration to actually shut down production, causing a dramatic decrease in demand. This decreased demand contributed to the drop in natural-gas prices, and is actually expected to continue for the near term. The EIA projects that U.S. demand for natural gas will grow by 1.6 percent in 2001, as compared to 5 percent in 2000.
Storage levels have increased. A significant increase in storage levels has also helped to keep gas prices comparatively low. The combination of mild weather and low prices has caused excess levels of natural-gas supply, which subsequently has been put into storage. According to the EIA, natural-gas storage is in surplus compared to last year's level at this time, and as of the end of June is even above the five-year average. Specifically, stored natural-gas levels are reportedly about 11 percent higher than they were last year and 3 percent above the five-year average. The EEA also corroborates these findings and reports that it expects storage injections to average about 12 billion cubic feet/day (Bcf/d) for July through September, a sharp increase from the average of 8.3 Bcf/d injected into storage during the same three-month period last year.
Production levels have increased. The high price of natural gas that was common through much of the last year has sent many production companies scurrying to increase their levels of natural-gas output. Ironically, this has now caused record-high levels of supply, which should now keep prices low. Demand gas production, according to the EIA, is estimated to have risen by 2.4 percent in 2000, and is forecast to continue to increase by 3.6 percent in 2001 and 2.9 percent in 2002. The EEA says that, with more than 60 GW of gas-fired generation expected to come online over the next 18 months, the total share of natural gas-fired generation is expected to grow to 17 percent in 2002.
Let's turn now to the impact that the fall in natural-gas prices may have on production companies and utilities that have a relatively large exposure to natural gas. The immediate future for these companies looks rather choppy as the uncertainty over gas prices continues to overshadow this sector. In fact, the Standard & Poor's oil and gas E&P index have both fallen over 20 percent this year, compared with a just-under-10-percent drop for the broadly based S&P 500 index.
I spoke with my contact at EIA yesterday and, based on projected gas production volumes in North America, the top five gas companies are BP Amoco, ExxonMobil, Shell Energy, Chevron, and Burlington Resources. Also included in the top ten are companies such as Anadarko Petroleum and Devon Energy. While most of these companies also have large oil production businesses, there is presently a great deal of concern surrounding both oil and natural-gas production ventures as prices in both sectors are on the decline. Presently, analysts claim that while these companies may still post year-on-year earnings in their 2Q 2001 reports (covering the period when gas and oil prices were still high), they expect the companies to post year-on-year declines in the third quarter.
In addition, some companies involved in the natural-gas business have seen their stocks take a hit. For instance, Anadarko Petroleum shares have dropped about 23 percent and Devon Energy shares have fallen about 19 percent. Further, Frost Securities, a securities brokerage firm in Dallas that specializes in energy and technology stocks, recently stated that it is warning clients that shares in independent gas- and oil-producing companies could fall another 20 percent in the near term. The firm also indicated that the glut in natural-gas supplies will most likely keep the commodity price low for the near term, unless market factors cause demand to suddenly increase once again. It is also interesting to note that several companies involved in oil and natural-gas E&P businesses have recently withdrawn their plans for initial public offerings (IPOs). According to IPO.com, companies operating in this space that have recently withdrawn their IPO plans include Basic Energy Services and CMS Oil & Gas Company.
On the other hand, even with the drop in prices, natural gas is still being sold at substantially higher prices than during the late-1990s. The comparatively high prices may still encourage investors to buy shares in natural-gas companies. However, after such a strong price curve in 1999 and 2000, during which time companies with a strong natural-gas portfolio saw their profits and stock prices jump considerably, the choppy year-over-year earnings reports that are expected to be released for 3Q and 4Q 2001 could deter investors that are more growth-oriented from pursuing such companies.
Those power companies that ventured into natural gas as a result of the strong price patterns don't show any signs of retreating from this market. Calpine Corp. (NYSE: CPN) is probably the best example of this. Calpine has engaged in an aggressive natural-gas consolidation strategy, having purchased Canada's Encal Energy, whose assets currently produce approximately 230 million cubic feet of gas equivalent a day and can access about one trillion cubic feet (Tcf) of proven and probable gas resources. In addition, Calpine announced plans to jointly develop the Sonoran Pipeline, a 1,160-mile high-pressure interstate natural-gas pipeline from the San Juan Basin in northern New Mexico to markets in California. Calpine's strategy is to fuel the vast majority of its power plants with natural gas, with 25 percent of that natural gas coming from company-owned sources.
The drop in natural-gas prices does appear to be a trend, at least for the first half of 2001. This market is subject to extreme volatility, however, and trends could change at any time. Yet, the best analysis available at this point indicates that the combination of mild weather, reduced demand, increased storage, and increased production should keep natural-gas prices relatively low for the next 12 months. While those companies involved in E&P efforts may see their stocks and year-on-year earnings take a hit, this must be taken in the context of a previous year in which earnings were exceptionally strong. Other power-generation companies such as Calpine that have incorporated natural gas into their portfolios do not appear to be impacted by the drop in natural-gas prices, as they are locking in supply and production companies that can be factored into their generation portfolios. |
