Tuesday, August 5, 2008

Recent Declines in Natural Gas Prices

I’ve been watching natural gas prices with clenched teeth lately. Since peaking over $12.50 three weeks ago, the natural gas spot price (Henry Hub) has been declining steadily. Yesterday it closed at 9.18 (up 1.7%), but it’s down nearly 30% since reaching its recent peak (although it is nearly 50% higher than this time last year). The price of crude oil has also dropped over this same time period. Publicly traded gas exploration companies are feeling a similar hit, as their stock prices have dropped precipitously over the past three weeks (Goodrich Petroleum -50%; Chesapeake -39%; Petrohawk -46%; XTO -40%, etc.).

Much of the decline started when the government reported in mid-July that natural gas supplies are currently higher than anticipated, which bodes well for the gas heat dependent residents of the Northeast going into winter. I thought this would lead only to a short term disruption of prices, but they kept going down. Upon further investigation, I found there is much more afoot, especially in the global arena.

Energy pricing usually boils down to supply and demand. When one is askew, prices follow. The energy story for the past year has been demand, both internationally and at home. As prices have increased, energy users have found ways to cut back, which has lessened demand, which has in turn lessened upward pressure on price. Some of these changes may be short term in nature, but they have impacted the market nevertheless.

On the supply side of the equation, there are two big issues. The first is international consumption of liquefied natural gas (LNG), especially in Europe. Because Europe has little natural gas supply of its own, prices there can be 50-100% higher than in the US. These high prices have lured LNG purveyors to export higher quantities to Europe rather than the US. In 2007, US LNG imports were down 60% from the previous year. With new international fields ramping up in Qatar, Russia, Nigeria, Indonesia and Yemen, analysts expect international LNG production to increase approximately 34% next year. It is expected that increased quantities of LNG will arrive on US shores, especially as new LNG ports are constructed.

The second supply issue is the projected increase in domestic supplies over the coming years. This is driven in large part by increased access to unconventional plays like the Haynesville Shale. Some analysts suggest that domestic supply will outstrip demand this year and next. This information certainly validates recent chatter by Chesapeake CEO Aubrey McClendon of exporting US natural gas to international markets.

Bottom line: commodity prices are determined in a market environment. A good is priced based on what someone is willing to pay for it. As a result, pricing is not firm and perception and anticipation have a large role in setting prices. Clearly the perception of market participants has changed recently and prices are headed in a negative direction. The news might be different tomorrow if, say, Toyota announces plans for a new natural gas powered car, but at this point it does not look like sustained prices over $10/MMBtu are realistic for the next couple of years.

One piece of good news for the publicly traded companies would be if they were able to hedge large quantities of their future sales when the prices were in the $12+ range. That news should come out in the next few months.

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