Energy Sector

Shoulder Season Masks Long Term Trends

by Joseph Dancy, LSGI Advisors, Inc. | October 9, 2008

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Energy use correlates closely with global economic activity. If the U.S. and global economies slow due to the ongoing credit crisis the growth in demand for crude oil and natural gas will be impacted. Keep in mind supply issues are present for both crude oil and natural gas, and unique demand issues also exist, so price trends in the energy sector may not track economic activity to the degree they have in the past.

Gasoline inventory. As we begin the fourth quarter gasoline inventories are at levels not seen in 40 years – well below normal levels and approaching minimum operating levels for the system. Severe shortages have arisen in Nashville and Atlanta and several areas in the Southeast, all due to the refinery shut-downs as a result of the recent hurricanes in the Gulf of Mexico.

As refineries restart gasoline output will remain below normal levels, and spot shortages might continue to appear in certain areas. The problem with shortages in select markets is that they tend to create a ‘run on bank’ behaviorally speaking, and tends to disrupt markets due to hoarding behavior. Once disrupted, it is difficult to get behavior to return to ‘normal’ once supplies are restored.

Minimum inventory levels needed to keep the U.S. gasoline distribution system functioning properly have been estimated at anywhere from 170 million barrels to 185 million barrels. Since we were recently at inventory levels of 178.7 million barrels we are approaching critical levels. We have not seen inventories this low since 1967, and we have never seen inventories this low on a days-of-consumption basis.

As of the first of the month around 430,000 barrels per day of refinery capacity remains shut down due to the hurricanes, and production of gasoline generally ramps up slowly when a refinery is put back online. As refineries resume operations the gasoline shortages in the Southeast will slowly be addressed.

Natural gas. Roughly 45% of the Gulf of Mexico’s natural gas production remains shut-in due to the hurricanes as of the first of the month – an area of the U.S. that produces roughly 15% of domestic natural gas supplies. Much of the shut-in production will take several more weeks or more to get back online – too late to add to the natural gas storage inventories needed for this winter’s heating season.

Natural gas demand peaks in the winter months (December to April) heavily driven by space heating requirements from the residential and commercial sectors. Interpolating the data the last few years, heating demand represented more than 50% of total natural gas demand during this period.

The extent of natural gas demand is thus driven by the severity of winter weather, not necessarily by economic trends, during these months as is evidenced by the chart at right (courtesy Credit Suisse).

So weather will be the driving force behind total natural gas demand, or lack thereof, and by proxy will heavily influence natural gas prices.

The reliance of the Midwest on natural gas will mean that weather in that part of the country will correlate closely with natural gas demand. The preliminary long term forecasts we have reviewed predict a ‘normal’ winter temperature-wise. Many of these forecasts will be updated at the end of this month.

Storage wise, we have roughly five weeks left of injection season. Natural gas in storage is 153 billion cubic feet (bcf) below last years level at this time and 217 bcf below levels two years ago at this time. From recent trends it appears that we will end the injection season with 3.30 trillion cubic feet (tcf) compared to 3.54 tcf last year and 3.45 tcf two years ago.

Peak winter demand, which will be satisfied to a large extent from storage facilities, will be highly temperature dependent. Total natural gas demand last winter and spring was roughly 10% higher than levels three years ago, so demand appears to be growing – the question is whether the growth was a function of the weather, a function of newly installed equipment, or both.

Natural gas on an energy-equivalent basis now sells at less than one-half the price of crude oil—a level low compared to historical norms. Natural gas is cheap, comparably, and when compared to heating oil for space heating purposes it is very cheap—as will become apparent to consumers this winter.

The cost to heat a home in New York with heating oil this coming year is estimated at around $3,760 – up from $1530 last year. The same house heated with natural gas would cost around $1,370 according to government estimates. Conversions to natural gas heating systems are in full swing, and we expect the fuel will capture more and more space heating demand if the price discrepancy continues.

U.S. natural gas production from both onshore and offshore sources has increased roughly 8% over year earlier levels. Several companies announced last month that with the weak pricing for natural gas they will slow drilling activity. Analysts estimate ‘break even’ costs for developing new prospects are now just over $8 a thousand cubic feet (mcf) – higher than recent futures prices.

The decline rate in many unconventional wells, including shale wells, is much higher than in conventional wells so any slowing of drilling activity could impact production. And offshore natural gas production has actually declined 3.5% over the last year. We expect the decline of offshore production to continue. Some of the offshore natural gas now shut-in due to the hurricanes will never come back online. A number of platforms were destroyed or otherwise damaged, as well as pipelines.

Canadian natural gas production has declined over the year ago period, and exports from Canada are down roughly 10% during that time frame (chart courtesy of Apache Corp). Liquefied natural gas imports to the U.S. are also well below year ago levels, and at current prices most non-contracted LNG cargoes will go to markets where natural gas prices are much higher (in many cases more than double the price level of those in the U.S.).

The natural gas model we follow closely remains very bullish for both the commodity and for natural gas related equities. Donald Coxe, BMO Capital Markets, in his September 10th monthly research report concludes “the biggest near-term upward surprise in commodity prices” could be natural gas. We agree.

Crude oil. The Energy Information Administration last month noted that U.S. demand for crude oil has fallen by 0.5 million barrels per day, but global demand has increased 1.3 million barrels per day. Since crude oil is a global commodity, the analysts focusing on demand destruction in the U.S. are only partially correct. Roughly 50% of U.S. crude oil production in the Gulf of Mexico remains shut-in due to the hurricanes as of the first of the month.

Russian oil output continues to disappoint. Production declined for the first time in a decade by 0.5% in the first eight months of 2008. Production from the world’s second largest producer was forecast to grow by more than 1%. Last month the government began examining the possibility of setting up a strategic reserve that can be used to influence prices, and they are looking to cooperate more closely with OPEC on monitoring global production levels.

Mexican oil production continued its downward spiral. For the first eight months of 2008 crude oil production fell 9.7% while exports dropped 16% compared to year earlier levels. A major concern is that the decline in production was led by its largest field, Cantarell, which dropped 29% to 1.11 million b/d, while output at the second-largest field, Ku-Maloob-Zaap fell 39% to 688,800 b/d.

The decline curve for the Cantarell field, a field that has seen production stimulated with a nitrogen-based enhanced recovery program, is quite steep. The field is one of the largest in the world. Cantarell produced less than 1 million b/d for the first time in 13 years in July and August. Petroleum engineers do not see the decline in production moderating any time soon.

Last month militant attacks on Nigeria’s oil industry resulted in the loss of around 1 million barrels per day of light sweet crude oil production. Both production facilities and pipelines have been targeted. Daily output is now roughly 1.5 million barrels per day. Nigeria is Africa’s largest oil producer and exporter.

In a presentation last month energy investment banker Matthew Simmons noted the biggest issue in the crude oil sector is the relentless growth in demand. The transportation sector relies exclusively on crude oil. The number of autos being manufactured worldwide continues to expand, even with the decline in car sales in the U.S.

Sales last month in China, the world’s second largest car market, were 15% higher than year earlier levels - a decline from the year earlier growth rates but still impressive. Analysts with China Petrochemical Corp. forecast that China’s demand for oil will increase by 6% in 2008 – in our opinion a conservative estimate.

Simmon’s notes that world productive capacity for crude oil liquids production is roughly 85 million barrels per day. The International Energy Agency forecasts global winter demand in the fourth quarter of 2008 and first quarter of 2009 will increase to roughly 88 million barrels per day – so global inventories will have to supply 3 million barrels per day to meet demand. Simmons claims the draw on stocks this winter could approach 450 million barrels, a very large number, and one that will most likely support higher prices.

Conclusion. While a global economic slowdown would reduce energy demand, supply and inventory issues should partially offset this decline in demand over the next six months – and in fact may cause energy prices to stabilize and perhaps resume their upward trend. We think the long term bullish trends in the sector remain in place.

© 2008 Joseph Dancy

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Joseph Dancy, Adjunct Professor, Oil & Gas Law, SMU School of Law, Advisor, LSGI Market Letter | Joseph Dancy's Book Reviews | E-mail