........................By George Hopley Illustration by Graham Fleming

The challenges now confronting North American natural gas markets are formidable. Despite starting the year with a seemingly adequate supply scenario of ample storage levels, rising rig counts and good prospects for increasing LNG imports, by the end of summer the reality of the "supply treadmill" had re-appeared. A very hot summer season, the warmest on record for a few states in the Northeast, drove air conditioner usage harder, forcing more gas burn by power generators than the last two summers.

Early in the injection season, the hurricane experts at the National Oceanic & Atmospheric Administration (NOAA) and elsewhere had broadcast their high confidence in an above-normal storm season and elevated that warning in August. Their fears were met early on with a fast start to the named storm count — fears that only worsened during the peak of the season as hurricanes Katrina and Rita delivered devastating blows to the Gulf Coast.

The impact on natural gas prices, both spot and forward, was swift and sure. In the two months prior to the .rst storm, the prompt NYMEX natural gas contract was averaging just more than $8 per million British thermal units (MMBtu). By the end of August, Katrina pushed prices above $11. Less than one month later, Rita made matters worse, forcing the highest contract settlement to date, as October rolled off the board at $13.907, and winter prices flirted with $15. Cash prices in eastern market areas stayed at a premium to Henry Hub, despite the shoulder season demand profile. Supply conditions remain in a challenged state, with the prospect for anything colder than normal in the 2005/2006 winter likely to keep the forward curve at risk to move higher again.

The occurrence of these discrete events in succession almost precludes historical comparison, instead calling to mind descriptions such as the energy market’s version of the "perfect storm." Yet, the precedent for adverse fundamental shocks has existed for a few years, as have the methods for helping to manage the financial risks of a volatile energy market. In early 2003, the prompt month contract rose from below $6 in the first half of February to spike above $9 for three at the end of the month, on cold weather fears and the apparent likelihood of running short of stored supplies. Earlier in late 2000, the prompt contract rose from below $5 November to run up above $9 in December through the half of January. In both cases, market prices retreated to spike levels within a matter of weeks, but the pattern was established that price evolution would follow signals of mental tightness in the market, whether real or perceived.

This winter season, market prices might not quickly from such lofty levels. Despite a growing base, especially in the non-core sectors of electric power industry, supply has remained relatively flat. The evidence emerging from the Energy Information during 2005 is that through July, cumulative dry gas production still lagged behind year-to-date output of began catching up after falling behind earlier in the The 2004 gas-oriented U.S. rig counts rose during the peaking at 1,082 in September, while the 2005 rig increased in succession and averaged at least 100 over in each week, according to Baker Hughes.

Even if the onshore rig count remains robust, the to the Gulf of Mexico drilling program of many will surely limit supply growth through the first half of In addition, many analysts had anticipated 2005 to be the imports of liquefied natural gas showed substantial to import totals, perhaps approaching the capacity limit one offshore and four onshore terminals, which on had not surpassed 60 percent utilization on a consistent Even though various exporting countries have brought liquefaction on-stream for the Atlantic basin in 2005, competition for spot cargoes on the high seas remains intense. United Kingdom and continental gas markets healthy appetite for LNG supplies, especially for the upcoming winter, and appear ready to pay for it. Finally, pipeline through the 2005 summer from have held steady the cumulative flow in 2004, but lately started to trend lower.

Canada has essentially the same mature basin issues as the United States does, without the hurricane component. Only limited imported growth can be anticipated there. To be sure, there are pockets of growth expected domestically, especially from non-conventional plays, such as coal bed methane from the Rockies. However, this only offsets the steep production declines in shallow water Gulf of Mexico and elsewhere.

Against this limited supply growth prospect, an increase in demand for natural gas shows ready potential. The key aspect of this growth is the weather-based component. As seen during last summer, warmer than normal temperatures had an adverse impact on weekly storage injections, quickly eroding the 200+ billion cubic feet cushion in working gas storage that persisted throughout the springtime. Even more dramatically, colder winter weather could force stronger space-heating demand and quicker withdrawals from storage, compared to the winter of 2004 and 2005, which was the eighth warmest on record. With a storage balance well below the practically full level of 3.3 trillion cubic feet in October 2004, this winter’s price formation is poised to remain quite sensitive to heating degree day counts in the biggest space-heating markets of the Midwest and Northeast. With the coldest days occurring on average in the second half of January, a fair amount of time must pass before conclusions can be reached about the winter’s ultimate impact on demand and prices.

Thus, two salient features of the current North American natural gas market stand out. There is increased sensitivity to winter and summer weather, worsened by limited supply capabilities and the remaining price-inelastic industrial demand. The resolution of such a tightly balanced market also comes only at a steep cost and adequate passage of time. To force demand off the market, either to competing fuels or to with-draw completely implies high opportunity costs. Growing the supply base, whether by increasing extraction of domestic resources or bringing new supply on-shore by transport of LNG, requires time to permit and develop the infrastructure necessary. Neither prospect will occur quickly.

Given these market conditions, a high level of price volatility can be ascribed to natural gas prices over the foreseeable future. To manage this price action, the growth of financial instruments has been profound, both in the volume of the benchmark Henry Hub futures con-tract traded on the New York Mercantile Exchange and in the increased use of over-the-counter products based either at Henry Hub or regional basis points representing other markets, outside of the Gulf of Mexico.

Since the price spike of 2003, open interest for all natural gas contracts has risen from above 300,000 to approaching 600,000, matching the all-time peaks set during early 2002. A big difference since then has been the recent increase in margin requirements, rising from $4,000 for spot month customers to more than $20,000 per contract this fall, making the latest contracting increases even more impressive.

With natural gas prices moving higher so quickly, the question for hedgers remains: higher still or retreat from here? The hurricanes have left significant damage in their wake, and the rest of the supply side needs to work hard to compensate for this lost production.

Such an inflexible profile could easily translate into higher prices should incremental demand emerge during the winter season. The higher oil prices currently offer not much relief to those who might switch. Into the first quarter and beyond, the consumption pattern of industrial users assumes greater importance.

For those industries that remained gas consumers after the price spikes of 2001 and 2003, margins have been com-pressed recently, and the need to pass on increased energy costs has become more immediate. For those who drop out of the market from here, their absence could eventually help rebalance conditions during the 2006 season, intimating the potential for some price weakness as well.

George Hopley is associate director and natural gas analyst at Barclays Capital.

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