Natural gas is used for heating/cooling buildings and water, drying clothes, cooking, lighting, generating electricity, waste treatment and incineration, metals preheating (particularly for iron and steel), drying and dehumidification, glass melting, food processing, and fueling industrial boilers among other things. So as you can see, the uses of natural gas and plentiful and since it costs far less than many other energy sources, we are not going to stop using natural gas very soon.
However, there is a problem brewing in Canada that if left unattended would drive natural gas prices substantially higher from today’s levels. The problem is that due to higher extraction, operating, labor and drilling costs, the costs of bringing a new well on-stream has risen substantially but since natural gas closed Friday at $6.56 US per million British thermal units in New York, many industry watchers and analysts predict a dramatic slowdown in drilling activity which in turn will negatively affect production growth.
Have costs really risen?
According to the Conference Board of Canada, the total costs for extracting natural gas last year (2006) increased by 10.1% and costs to drill and bring on a new gas well averaged about $5.05 per thousand cubic feet last year compared to $1.90 in 1995. Additionally, operating costs are expected to rise an average of 4.1% per year between 2007 and 2011. The result, according to the Conference Board of Canada, is that industry profits fell to $9.5 billion in 2006, about 25% lower than 2005's $12.7 billion. The board also expects natural gas production to increase by only 0.2% this year. Production and gas exports will then decline in the coming years, as conventional gas production in Alberta steadily declines.
Impact on Drilling Activity?
Industry groups such as the Canadian Association of Oilwell Drilling Contractors and the Petroleum Services Association of Canada are expecting a 20 per cent drop in the number of wells drilled this year -- the first year fewer than 20,000 wells will be drilled in more than half a decade. Evidence of this drop is already being seen in rig utilization rates in Western Canada as data released last week showed a mere 231 rigs working, less than half last year's 473. Even multinational companies like Nabors (NBR:NYSE), which operates 81 drilling rigs and 180 service rigs in Canada are feeling the price pinch, as evidenced by the following comment made by Nabors CEO Gene Isenberg in a conference in February: “Our lower 48 and Canadian results have been adversely affected by the gas prices.”
So why is a drop in drilling activity so important when levels of natural gas in storage are nearing 5 year highs?
Storage Levels of Natural Gas
The reason is because Canada is not replenishing its natural gas supplies at a quick enough pace to meet existing and future demand. According to the Canadian Association of Petroleum Producers, Canada is the world's third-largest natural gas producer and the number one supplier of gas imports to the U.S. Canada produces about 6.2 trillion cubic feet annually, and exports more than half of it to our neighbors south of the border. Total gas exports fell nominally in 2006, by about three per cent, however Martin King, a commodities analyst at FirstEnergy Capital Corp., expects that figure to accelerate to about 12 per cent, or more than a billion cubic feet a day, by the end of the year. King believes the numbers are a manifestation of lower drilling activity as big producers like EnCana Corp. (ECA:TSX) and Canadian Natural Resources Ltd. (CNQ:TSX) have pulled back on capital spending. Additionally, according to Bill Gwozd, Vice-President of gas services with Ziff Energy Group, Alberta's oil sands use 600,000 cubic feet a day to generate steam and power needed to separate oil from the tar-soaked sands. That figure is expected to rise to two billion cubic feet per day by 2015, a four-fold jump due almost entirely to the proliferation of new in-situ oil sands projects. In addition to growing demand for oil sands, the province of Ontario is increasing its own natural gas demand as it retires aging coal-fired power plants to reduce carbon emissions. At the same time as demand is increasing, he says Canadian production is expected to fall to about 17 bcf per day from about 18 bcf at present. Furthermore, Gwozd added that by 2015, Canadian production will be down by at least three bcf per day while demand will be up by three bcf per day. Ziff's analysis includes several key assumptions, most significant that the Mackenzie Valley pipeline comes into service by 2014 followed by Alaska in 2018. Any additional delays would exacerbate an already gloomy supply picture, Gwozd said.
So how high must Natural Gas prices go before drilling activity can resume at its required rate?
Expert firms such as Ziff Energy and FirstEnergy Capital Corp. estimate the natural gas industry now requires natural-gas prices of $8.50 to $9 per thousand cubic feet to recover costs and generate a 15 per cent return, a big difference from natural gas prices in Canada today, which hover around $6.56.
Natural Gas Price from a Technical Standpoint
After failing to breakout from around the $8.50 price level natural gas has now broken below both its 50 and 200 day moving averages. Although the MACD indicator seems pretty bearish for natural gas at the moment, both the RSI and slow Stochastics are showing sings of a bottom. So I think natural gas might drift between a $5.75 and $6.50 which has been its historic trading range, for the rest of the summer season.
Fundamental Outlook
With natural gas in storage at sufficiently high levels, there exists no immediate impetus for prices to head higher. However, if a major hurricane does happen to strike that could send natural gas prices upward by about $2 or more. In the absence of a major hurricane, however, natural gas will continue to drift sideways and remain in a trading range (between $5.75 and $6.50). Additionally, with the Canadian dollar hitting 30 year highs against the U.S. dollar, producers exporting to the U.S. are also feeling the pinch currency wise. So all in all, the near term picture for natural gas isn’t looking too good and hence the future call for higher natural gas prices on my part because current natural gas prices don’t support a reasonable environment for natural gas producers and explorers to continue searching for and replenishing their diminishing supplies. With little investment going into searching for new supplies and demand remaining stable, the supply demand picture gets skewed and eventually prices will go up to reflect that imbalance.
Summary
As a long term investor I’m convinced we’re going to have higher natural gas prices. As the uses of natural gas will continue to remain, demand will also remain robust however, due the points I have outlined above supply will eventually become constrained due to lack of drilling. For drilling to resume natural gas prices have to average $8.50 to $9 per thousand cubic feet for prolonged periods of time in order to inspire and cause existing producing companies to increase their cap ex budgets. So, as natural gas prices continue to move sideways and drift lower during the summer, it makes sense to chip away and accumulate positions in low cost producers.
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