Natural gas prospects growing: Current weakness offers entry point as demand to rise

by Levi Folk | May 14, 2007

According to the International Energy Agency (IEA), “the world ‘dodged a bullet’ in 2006 but gas remains vulnerable and expensive.”

An exceptionally warm winter in 2006 led to a major correction in gas prices and a subsequent pullback in spending in Canada. The price reversal is proving temporary and so should spending.

Companies associated with gas production present a long-term investment opportunity, with current weakness providing an entry point.

Spending on natural gas production will continue to grow over the coming decades. Cumulative spending on gas supply infrastructure is slated to rise by $3.9-trillion, according to the IEA World Energy Outlook 2006. Tellingly, capital spending needs are greatest in OECD North America, where demand “increases strongly” and where “construction costs are high.”

Record drilling in Canada and the United States sent rig rates substantially higher with little to show for the efforts in terms of net production growth, which remains “essentialy flat,” the IEA says. The number of wells drilled in the United States and Canada almost doubled between 2002 and 2006.

Gas prices spiked higher on tight fundamentals in 2005 only to retreat on excess supply associated with a very warm winter in 2006. After peaking at US$15 per MMBtu, prices bottomed at close to US$4/MMBtu in September, 2006. As a result of softer prices that were exacerbated by a rising Canadian dollar, Canada’s biggest gas producers cut back on capital spending going into 2007. Approximately US$7-billion was cut from US$33-billion in conventional industry spending in Western Canada, the IEA says.

As a result, companies providing services to and drilling for gas producers in Western Canada have been hit hard by the pullback. Drilling utilization rates were very weak in the first quarter of 2007, near lows reached in 2002 at the bottom of the market.

Yet the market for natural gas has already started to recover. Storage levels have declined in the first quarter of 2007, and U.S. demand for natural gas is estimated to jump by 2.9% in 2007. Prices have roughly doubled to just south of $8/MMBtu recently. But stock prices continue to languish. The S&P/TSX Oil & Gas Drilling index is off 20%from its January, 2006, high.

As prices for natural gas remain firm and new supply continues to languish especially due to reduced drilling, capital spending budgets will undoubtedly rebound. Investors should consider this pullback as temporary and buy in to North American oil and gas equipment and services stocks, and Canadian drilling companies with a long-term view. Canadian income trust Precision Drilling Trust comes to mind, as does U.S. oil services company Halliburton Co. Both have suffered from reduced Canadian capital spending for gas production in 2007.

As demand for natural gas increases over the next decade, North American supply is not expected to keep pace with existing demand, and consumption will become increasingly dependent on imported gas in liquid form. The liquid natural gas (LNG) market is booming and will continue to be a major area of spending over the next twenty years.

Liquid natural gas is gas that has been cooled to achieve liquefaction. Gas is then shipped in special containers and regasified through heating upon delivery. While this market is destined to grow substantially, there are serious concerns associated with supply due to cost overruns and delays with major gas-producing projects overseas. This is a crucial factor because 12 U.S. terminals are destined for completion by 2012 totaling 120 Btu of capacity equal to 25% of 2005 demand, the IEA says.

Russia has the largest natural gas reserves globally, yet there are serious concerns about supply over the next few years. There is a distinct trend toward state appropriation of “strategic assets,” and natural gas production may be suffering as a result. Gazprom, the state-controlled gas producer that produces roughly 90% of national gas output, snubbed foreign production companies for the development of its Shtokman gas field in the Barents Sea. The go-it-alone strategy could have implications for production: The IEA reports that initial production will not begin before 2015 rather than the 2011 initial target.

Royal Dutch Shell PLC and two more minor Japanese players were forced to accept halved stakes in the Sakhalin-2 gas project in the Russian Far East after the initial production-sharing agreements were overturned. The Russian government was incensed at the roughly US$10-billion cost overruns, which would have reduced its take on the project. The important point here is the cost overruns and potential for production delays on major gas projects.

In Qatar, the world’s biggest producer of LNG, cost escalation has also been a major problem. Capital costs for these projects have jumped six or seven times to US$135,000 per daily barrel of capacity. Perhaps not unrelated to these developments, Exxon Mobil Corp. has pulled the plug on a US$7-billion gas-to-liquids project in Qatar.

he U.S. natural gas market will become increasingly reliant on these overseas gas projects. Delays and cost overruns will increase the risks of supply shortfalls over the medium to long term. Gas prices will need to be higher to induce Canadian production and that will have a positive effect on North American service companies and drillers.