When will natural gas prices turn?

Record warm temperatures made for a comfortable Canadian winter this year. But they’ve caused a chill in the energy market. Particularly natural gas prices which dropped to a 15 year low.

What’s the cure?

“Low gas prices” is the standard response from industry experts. Low prices spur demand and cut off supply. It’s just a lesson in economics.

Natural Gas Demand

Demand for natural gas is increasing on several fronts – electricity generation, manufacturing and transportation.

Electricity generation

U.S. electricity generation consumes 21 BCF/day (billion cubic feet per day) which is 6 BCF/day or 40% more than last year and is trending higher (Fig. 1). This increase of 6 BCF/day represents a full 9% of total US supply of 63.9 BCF/day for 2012.

North America had the warmest winter in 80 years and demand for heating was down 8 BCF/ day through March 2012 compared to a typical year. The net decline in demand over the first 90 days this year of 2 BCF/day (6 less 8 ) will reverse for the balance of 2012 due to the overall higher electricity generation demand. The U.S. National Weather Service has predicted temperatures above normal for July and August throughout most of the country which creates higher demand for natural gas as more electricity is used for air-conditioning.

Manufacturing

Industrial demand for natural gas is on the rise as companies take advantage of lower prices. Plastics and chemical factories are large consumers of natural gas. New facilities are scheduled to open in the next several years as the less expensive U.S. natural gas prices have drawn these industries from Europe and Asia where prices are much higher. For example, a new $6 billion chemical factory was recently announced in Pennsylvania to take advantage of the abundant shale gas from the region.

Transportation

Cheaper natural gas is compelling transportation companies to convert diesel fueled engines to cleaner burning natural gas engines. According to a recent analysis conducted by the Conference Board of Canada, a long-distance trucker could save nearly $160,000 over a decade by converting from diesel to natural gas. Vancouver-based Westport Innovations and its partners shipped 5,739 natural gas engine units in 2011, up 46 per cent from the prior year. Major energy companies like Royal Dutch Shell PLC have committed to build natural gas refuelling infrastructure in high-traffic areas in western Canada. U.S. truck stop company, Pilot Flying J, which currently pumps liquid natural gas (LNG) at just three locations, plans to grow that number to 30 by year end, and 150 within two years.

Natural Gas Supply

The supply of shale gas and technological advances in its extraction have been the major contributors to lower natural gas prices in North America. The horizontal drilling and fracking process is very efficient in producing large volumes of gas in the first year, but leaving less to extract in subsequent years. This decline rate (the reduced rate of production for an average well from one year to the next) has increased to 32% from 18% over the past ten years. A consequence of rising decline rates is that more drilling is needed to replace reserves. Drilling is costly and becomes uneconomical at lower natural gas prices. Gas companies across North America have reduced their drilling activity by 30% to its lowest level since 2002. A reduction in drilling will lead to reduced supply later this year. Simply, the commodity price will have to rise before companies will allocate more capital for future drilling.

Unlocking North American Supply to Foreign Markets

Natural gas is traditionally a local market requiring pipelines to get the product to market. Overseas, where there is little supply, natural gas has been trading at nearly $16 in Japan and nearly $13 in Europe compared to less than $2 in North America.

This price disparity creates an opportunity to sell North American natural gas overseas. The development of LNG* terminals on both the west and east coast along with export pipelines to feed these terminals has now become a priority for the Canadian government along with some major companies.

In Canada, Kitimat on the west coast is home to three large planned and licensed export facilities to ship gas from western Canada to Asia. These are expected to come on stream beginning in 2015. A natural gas pipeline is planned from North East B.C. to Kitimat. Cheniere Energy has received an export license from the U.S. government for up to 2.2 billion cubic feet per day by 2015. Sempra Energy announced plans for a $6 billion LNG export terminal, which would be the third large scale LNG exporter in the U.S. In total up to 15% of the current North American production could be exported by 2016 from these facilities. As these projects get closer to completion one would expect the difference in natural prices to converge to create a global market and price for natural gas.

The Opportunity

The natural gas producers have followed the price of the commodity in a downward spiral over the last six months. Demand is continually rising and supply will decline at these low commodity prices. Eventually, natural gas prices will begin to rise as demand/supply moves toward equilibrium. Until then, the prices of most North American natural gas producers will remain mired at depressed prices. Investing today at these prices with a longer time horizon may offer investors some significant upside as the price for natural gas stabilizes.

We currently own Tourmaline Oil Corp. (TSX:TOU) and are looking at other ways to participate in what we see as an attractive buying opportunity in the natural gas market.

* Liquefied Natural Gas (LNG) terminals allow for the transportation of natural gas using LNG tankers that carry the natural gas in a liquid state which is easier for transport. Liquefied natural gas takes up approximately 1/600th the volume of natural gas in the gaseous state.