As 2003 approaches, the potential for tight supply and demand fundamentals has increased. As a result, the Simmons & Co. International's outlook on the North American natural gas markets continues to improve. The US natural gas production treadmill is more visible than ever, and with a lethargic rig count that continues to show no signs of recovery in the near-term, 2003 production will likely decline 1%.
The natural gas import situation has changed materially over the past few years, as Canadian production is at a zenith. Imports from Canada could decline next year, while US natural gas exports to Mexico are on an increasing trajectory. The burden to increase US gas supply increasingly rests on the untested shoulders of LNG.
Industrial expansion, i.e., increasing industrial gas demand, is not likely to occur in 2003. Market tightness and the resulting strong prices will squeeze out any industrial demand increase to ensure that gas storage fills to minimum levels next year. In other words, over the next 12 months, gas storage levels will move from near full (3.2 tcf) to an estimate of minimum full (2.7 tcf), such that there is not room in the supply and demand calculus to accommodate industrial demand expansion.
Snapshot of important variables
A flat industrial demand for gas is expected in 2003 with a 400 MMcf/d increase in residential/commercial demand and a 1 bcf/d increase in power generation demand. US natural gas demand will increase by 1 bcf/d (or 2.1%) over 2002, driven by continued growth in the electricity sector.
Overall supply will be flattish in the US markets as the US production decline of 800 MMcf/d is partially offset by an increase in imports of the same magnitude. Simmons & Co.'s model indicates that US production will modestly decline because 2003 drilling activity will likely be slow to ramp-up from relatively subdued 2002 activity levels. Canadian imports will be flattish, and increasing Mexican exports will effectively offset increased LNG imports. Expect 2003 net imports to increase slightly compared to 2002.
Assuming an 8% warmer than normal winter, gas in storage on March 31, 2003, will approach 1.2 tcf, compared to 1.52 tcf on March 31, 2002. With low levels of storage entering the 2003 refill season, storage levels should not exceed 2.7 tcf entering the 2003-2004 winter.
Reflecting the improved fundamental view of the gas market, Simmons & Co. increases the 2003 Henry Hub natural gas price forecast from $3.30/Mcf to $3.80/Mcf. The process of forecasting prices is inherently challenging, and the point estimate ($3.80/Mcf) is intended to reflect Simmons & Co.'s view of positive supply and demand fundamentals. A material oil price correction (down to $20/bbl) remains a risk, as it could create wide-spread fuel switching away from gas. With a $25/bbl WTI oil price forecast in 2003, however, 2003 gas prices will average something closer to $4/Mcf than $3/Mcf.
2003 supply and demand outlook
The outlook for the 2003 natural gas market hinges on storage. With year-over-year declines in supply coupled with likely positive year-over-year demand growth in the residential/commercial sector, storage should approach 1.2 tcf at the end of March 2003 compared to 1.52 tcf at the end of March 2002. Given supply constraints, storage will just be able to reach "minimum full" levels of 2.7 tcf before the start of the 2003-2004 winter heating season. Demand to refill storage during spring and summer 2003 will be inelastic. Demand for gas to generate electricity will also be relatively inelastic. But this will allow for no recovery in industrial demand during 2003. Prices are likely to reach equilibrium at the level required to discourage growth in industrial demand for gas.
A key element to the supply and demand model is the recognition that end-of-season storage levels have a relatively tight range between "full" (3.25 tcf) and "minimum full" (2.7 tcf). Even though theoretical working gas in storage is considered to be near 4 tcf, practical full levels are near 3.25 tcf. As storage approaches this level, aggregate storage injectivity is diminished. And in some cases, not all the natural gas available for storage can be injected. This results in some forced production curtailments, which occurred toward the end of the injection season in both 1998 and 2001, years when working gas approached/exceeded 3.2 tcf.
The minimum required storage at the end of the injection season is 2.7 tcf. This is the aggregate amount of gas storage required to meet anticipated winter demand. During 1996 and 2000, natural gas storage slightly exceeded or just met the "minimum fill" requirements. In fact, during the 2000 summer injection period, natural gas prices rose to over $5/Mcf as injection demand competed with cooling/industrial demand for the available wellhead supply. High prices reduced demand by encouraging fuel switching and knocking some marginal industrial demand off-line.
US working gas storage volumes historical seasonal "end-points."
The important takeaway from this discussion is the need for local natural gas utilities to have adequate natural gas storage inventories before the onset of winter heating demand when demand exceeds supply.
Too much vs. not enough
The fact that there is only a 550 bcf difference between "full" and "minimum full" storage emphasizes the slim margin between "too much" and "not enough." Relatively slight changes in supply and demand can transform a market that has "too much gas" into one that is "tight." The 550 bcf difference in storage is equivalent to a change of 1.5 bcf/d in supply or demand (or a combination) over a 12-month period. This is precisely the situation in this forecast for 2003. Storage will end the 2002 injection season at nearly 3.2 tcf.
Using a conservative set of assumptions, it appears that industrial demand should be cut slightly (1%) in 2003 to ensure storage levels approach 2.7 tcf. This situation is driven by a combination of continued growth in gas-fired power generation demand and continued declines in US natural gas production.
Changes in the supply/demand model
There are some likely sensitivities to this base case supply and demand model and the resulting projected natural gas storage levels. For those cases where the end of 2003 injection season (Nov. 1, 2003) ended below 2.7 tcf, industrial demand was cut to achieve minimum storage levels in front of the winter of 2003-2004. To achieve storage levels that are near full, i.e., 3.2 tcf, the model has to reflect a normal winter and 1% supply growth during the first three quarters of 2003, a combination of events that is highly unlikely.
Based on this sensitivity analysis, the most important variables to watch over the next few quarters are US supply and weather. If the weather is 8% colder than the model, industrial demand will have to contract 1.8 bcf/d during 2003 to ensure adequate storage.
Natural gas price forecast
Reflecting the revised analysis of 2002 and 2003 gas market fundamentals, the 2002 and 2003 Henry Hub natural gas price forecasts change from $2.93/Mcf and $3.30/Mcf to $3.25/Mcf and $3.80/Mcf, respectively.
No article about natural gas is complete without emphasizing the volatility associated with gas prices. The physical and financial drivers of price make specific price estimates an effort almost doomed to frustration. Prices forecasts are more useful to indicate the fundamental outlook for North American natural gas markets. The current revision from $3.30/Mcf to $3.80/Mcf for 2003 highlights the belief that the North American energy patch looks quite healthy in 2003.
Realistically, the expectation is for the 2003 average gas price to fall within +/- $0.50/Mcf of the $3.80/Mcf forecast. If the assumptions here are too conservative, prices will necessarily be higher to knock some industrial demand off-line to ensure adequate storage for the winter of 2003-2004.
What can go wrong with this positive outlook? Demand contraction via a double-dip recession could further weaken US industrial demand and ultimately impact electricity growth assumptions. Also, crude oil prices could weaken, pulling down natural gas prices. With that said, Simmons & Co. maintains the $25/bbl oil price in 2003 on the basis that the potential for sustained low prices is unlikely, while the potential for significant upward excursions of natural gas prices is possible given the tight supply and demand outlook. Price spikes to entice fuel switching/demand contraction could over-correct, resulting in very high, and then lower natural gas prices – a replay of 2000 and 2001.
Author's Note: This article is a synopsis of a research report. The original report was published Nov. 9 and is available at the Simmons & Co. International website at www.simmonsco-intl.com.