"Canada Sounds the Alarm" by Bill Powers. FSO Editorial 04/21/2010

FSO Editorials

Canada Sounds the Alarm
by Bill Powers
Editor, Powers Energy Investor
April 21, 2010

Last month the National Energy Board of Canada (NEB) issued a report entitled, “Short-Term Canadian Natural Gas Deliverability 2010-2012” which confirms my prediction about the strong likelihood of a significant and imminent decline in both Canadian natural gas production and natural gas exports to the US. In the 12 page document, the NEB provides three different price scenarios between 2010 and 2012, a high-price, mid-price and a low-price scenario. In each case, Canada’s natural gas deliverability and exports to the US decline. While I agree with many of the conclusions the NEB reaches in its report, I believe the NEB overstates Canada’s gas deliverability even in a low price scenario. Recent declines in Canadian natural gas prices and high levels of storage will result in a near shut-down of Canadian natural gas drilling activity for the balance of 2010. A dramatic fall in drilling will result in a sharp fall-off in natural gas production in the second half of 2010 and beyond. Investors should be aware that declining Canadian natural gas deliverability will have a profound impact on the North American supply/demand balance over the next two years.

While the NEB’s predictions probably come as a surprise to most US market analysts, they should not come as a surprise to readers of this publication. In the July 15, 2009 mid-month update, I had the following to say about the future of Canadian exports to the US in a piece entitled “The Natural Gas Import Myth”:

“While LNG import trends have received much attention by energy market observers, the US imports far more natural gas from Canada, making this northern neighbor the most important source for imported gas. The ending of the Royalty Trust corporate structure in 2011 and Alberta royalty rate hikes (which have been temporarily reversed), along with the high cost structure for natural gas drilling in Western Canada, have caused natural gas drilling to plummet over the last four years.”

I followed up the above discussion with a prediction of reduced Canadian exports to the US in my December 1, 2009 article entitled “The Gas Crisis of 2011”, which contained the following prediction:

“I expect Canada’s exports to drop to approximately 150 billion cubic feet (bcf) per month by June 2011 or by approximately 4 bcf per day over the next 19 months.”

For readers who are not familiar with Canada’s natural gas production history, a little background may be helpful. After reaching peak production of approximately 17 billion cubic feet per day (bcf/d) in 2001, Canadian natural gas production fell to 14.4 bcf/d by the end of 2009, a 15% decline. (Source: NEB, Natural Resources Canada). Much of this decline was the result of high-cost conventional production from the Western Canadian Sedimentary Basin (WCSB) getting squeezed out of the North American market by lower cost American production. While Canada has two of the most promising shale prospects in North America, the Montney and Horn River Basins, declining Canadian conventional production is not only overwhelming growing shale gas production, it is the root cause of the coming massive decline in exports to the US.

As I previously mentioned, the NEB has outlined three deliverability scenarios for the period 2010 to 2012. Below is snapshot of each scenario taken directly from the report:

The mid-price scenario (NYMEX prices range from $5.50 in 2010 to $6.75 in 2012) results in a continued decrease in deliverability over the projection, from 15.1 bcf/d in 2009, to 13.0 bcf/d in 2012. Gas drilling activity would rise by 19 percent in 2010, then by less than 10 percent annually in the two following years.
In the high-price scenario (NYMEX prices range from $6.50 in 2010 to $7.75 in 2012), deliverability decreases in 2010 to 14.2 bcf/d then shows a marginal decrease in 2011 to 13.9 bcf/d before rebounding in 2012 to 14.3 bcf/d. Gas drilling activity rises sharply in this scenario, by a total of 64 percent over the projection period.
In the low-price scenario (NYMEX prices range from $4.25 in 2010 to $5.25 in 2012), deliverability continues to drop over the projection to 11.6 bcf/d in 2012. Drilling activity continues to fall and averages 60 percent of 2009 levels throughout the projection. The areas most sensitive to these scenarios are the more marginal conventional plays, while unconventional development would likely proceed in all but the most negative reality.

While I commend the National Energy Board for attempting to get out in front of such a critical issue such as the deliverability of natural gas, I believe their projections of deliverability in every scenario are too optimistic for two reasons. First, current gas prices are below even the low case scenario outlined in the report. In the low-price scenario, the NEB has NYMEX natural gas averaging $4.25 per million British Thermal Unit (MMBTU) in 2010. While today’s price is approximately $4.00 per MMBTU, I believe this small difference will devastate plans for natural gas directed drilling in Canada for the rest of the year. Even with higher natural gas prices in January and February of this year, natural gas directed drilled fell substantially from the year ago period. The below table makes clear the drop off over the last year in Canadian natural gas directed drilling:

Canadian Natural Gas Drilling

Month	Wells Drilled	Change from Prior Year
Feb 2010	483	-55%
Jan 2010	343	-58%
Dec 2009	144	-94%
Nov 2009	231	-83%
Oct 2009	195	-85%
Sep 2009	179	-85%
Aug 2009	243	-70%
Jul 2009	214	-44%
Jun 2009	206	-3%
May 2009	266	-55%
Apr 2009	589	-35%
Mar 2009	885	-21%

*Source: Natural Resources Canada

With only 826 natural gas wells drilled during the first two months of 2010, Canada is on track to drill approximately 2,500 gas wells in 2010 versus the nearly 4,000 that were drilled in the 12 months ending in February 2010. It should be noted that January and February are historically the two most active drilling months in Canada since winter-only drilling areas are accessible. Few Canadian operators have any incentive to drill natural gas wells at today’s prices and this will result in a near 20-year low in Canadian gas-directed drilling activity in 2010.

Another reason the NEB’s low case is too optimistic is that the Board is underestimating the declines that are already eating away at Canada’s existing production base. Based on a 15% annual decline in Canada’s natural gas production from year-end 2009 levels due to the near complete shut-down of gas directed drilling, Canada will begin 2012 with only 10.4 bcf/d of natural gas production. In other words, at least 4 bcf/d of production will be lost over the next 21 months. Considering the US imports approximately 6.5 bcf/d from Canada, a loss of 4 bcf/d in the immediate future will have a dramatic impact on US natural gas prices.

With Canada’s National Energy Board sounding the alarm that the country’s natural gas deliverability is headed for a major decline, it will not be long before Wall Street analysts catch on to what I believe is one of the largest factors impacting overall North American deliverability. It is difficult to overstate how important Canadian production and exports are to the North American natural gas supply/demand balance. Consider the following. Declines in Canadian natural gas imports to the US over the next two years will be nearly equal to halting production from America’s biggest field, the Barnett Shale. I expect that the drop in Canadian imports will push natural gas prices into the double-digits by mid-2011 if not sooner.

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© 2010 Powers Energy Investor, LLC. Information presented in this article was obtained from sources believed to be reliable but accuracy, completeness and opinions based on this information are not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein. The editor may have an interest in the companies mentioned. All data and information and opinions expressed are subject to change without notice.

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