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Living on the Edge

Putting natural-gas price volatility into hurricane-season perspective.

Fortnightly Magazine - August 2006

remain backward-dated for the remainder of the price strip. When historical average Henry Hub prices from January 1997 to January 2000 are observed, the most notable trend appears to be that the annual average spot price in nominal terms settled around $2.00+/MMBtu on average. Although fundamental market events did cause brief price responses, the price tended to migrate back toward this value.

Much of this period of natural-gas price stabilization can be attributed to excess investments in production and transportation capacity relative to demand needs. Production growth began to accelerate in the late 1980s and continued through much of the 1990s, with production peaking in 2001. Figure 5 shows a graphical representation of daily Henry Hub spot prices since 1997.

A major market event of the late 1990s occurred in the winter of 1996-1997. Winter prices peaked, reaching the $4.25/MMBtu level. Market volatility also was supported by thin storage inventories. The same pattern was set for 1997-1998; anticipated cold winter weather never materialized. In fact, heating-season prices traded at roughly $1.00/MMBtu lower than shoulder month prices. Mild winters in 1998-1999 and 1999-2000, combined with ample storage, kept volatility and price levels low.

Market dynamics began to change in 2000. Working gas injections between April and October resulted in season-end totals of only 2,700 Bcf—some 500 Bcf below total storage capacity. Injection efforts were bleak, caused in part by record gas-fired generation demand during the summer that also was caused by low hydro-electric generation during the same time period.

From the alignment of these market fundamentals and previous observations, it could be assumed that heating season prices would spike if average weather or any other significant market event were to occur. In fact, prices did spike. Market momentum drove prices to reach a monthly average peak of $9.50/MMBtu in December 2000. Figure 6 shows working gas storage levels and compares the low 2000 peak level with other years as well as the actual peak for Nov. 1, 2004—an all time high.

Why did natural-gas prices during the heating season of 2000-2001 eclipse previous highs? Extreme volatility could not be caused by weather alone. Some have argued that other dominant market forces—such as unscrupulous trading activity and the record low hydro generation level during the California energy crisis—played significant roles. After the dust settled, natural-gas prices again retreated to the $2.00+/MMBtu level by September 2001, and remained there throughout the 2001-2002 heating season.

At the time, the market was driven by mild heating-season weather and abundant storage. However, some extreme causal effects resulted from this period of docile natural-gas prices. First, the low prices curtailed the fervent drilling pace that resulted from 2000-2001 price strength. Second, year-over-year production levels for the first quarter of 2002 decreased on the order of 3.5 percent. The factors that drove the production decrease can be debated; however, in our opinion, the decline in production likely was attributable to:

• Drilling inactivity, which intensified natural gas field decline, reduced the chance for new field discoveries, and curtailed field extensions; and

•Lack of demand and the resulting impact on end-of-season