It is a simple equation of supply and demand.
Step 1. Massive shale gas discoveries in the USA and British Columbia brought an increased supply of natural gas to the market. The recession has seen traditional industrial consumption of natural gas decline.
Increased supply + decreasing demand = lower prices.
Step 2. Producers start shutting off production. Exploration and development activity is postponed as lower prices do not make economic sense for larger corporations. Lower production levels no longer fully replenishes inventory supplies.
Step 3. Stored inventories of natural gas supplies start to decline even under lower demand conditions.
Step 4. Supply falls faster then demand.
Step 5. Supply falls below demand. Prices come under upward pressure but supply continue to fall as producers wait for solid trend indicators.
Lower supply + higher demand = higher prices (Note: Demand does not necessarily have to increase. The point here is that supply fulls below current lower demand resulting in a demand that is now higher then the inventory supply)
Step 6. Higher prices justify increased production, exploration and development.
This is a simplified sequence of events with many factors taking place that can impact the process. The important lesson here is that supply falls faster then demand and eventually surpasses lower demand levels. It is at this key juncture that industry scrambles to meet the demand and prices will likely start to appreciation appreciate again. The risk is they could spike up and the choke on supply comes down the pipe.
According to the US Energy Department ~45 percent of US rigs have been shut since September which means Q4 gas production will tumble 5.2 percent, faster than the 1.9 percent decline in use. In January 2009, the Alberta rig count was the lowest it has been since 1993 with only 36% of the Alberta fleet active. (Operators moved 15% of the Alberta fleet to BC and Saskatchewan). John Tasdemir, Analyst with Tristone Capital, projects 2009 will see lower exploration with 14,500 new wells to be drilled in Western Canada, compared with ~17,000 in 2008. Drilling activity was at a peak of 22,000 in 2006 when natural gas prices rapidly appreciated on supply constraints and sharp demand.
One concern that makes the puts increased drilling activity at risk is the impact of current market conditions. Investment banks and private equity are holding onto capital tighter then before and may be slower to respond even when prices start to appreciate and drilling activity would lag behind struggling to keep up with demand. Prices would continue to be under upward pressure.
According to a Bloomberg News survey of 20 analysts, natural gas prices will rise to US$7 per million British thermal units by January from US$3.85 today on the New York Mercantile Exchange representing the largest gain since the first half of 2008.
What some of the industry players are quoted as stating:
Martin King an analyst at Calgary- based FirstEnergy Capital Corp. states, “We’re starting to see a downward production trend” for natural gas”.
Larry Nichols, CEO of Devon Energy Corp. states, “When the recession ends and the economy starts booming, we’re going to have less natural gas than we do today and prices are going to spike back up. The drop in supply will be so steep, it could easily catch up to where demand has dropped to before the recession ends”.
Stephen Schork President of the Schork Group Inc. energy markets consultant in Pennsylvania stated, “The next big move for gas is obviously going to be up. If we are higher, I’d expect to see us at $7 by the start of next winter”.
Theresa Gusman, head of equity research for Deutsche Bank, New York, states, “These dramatic cutbacks in capital expenditures are going to lead to shortages as we move through this recession and come out the other end”.
Bloomberg.com – “Natural Gas Rigs Shutting Means Prices May Double”