Living on the Edge


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

Fortnightly Magazine - August 2006

The natural-gas and oil price run-up since hurricanes Katrina and Rita has subsided somewhat following a warmer than usual winter, record natural-gas storage levels, and successful conservation instituted by many gas and electric utilities in recent months. However, new sources of supply concern—such as occurred in Europe with accusations of gas-supply withholding between former Cold War adversaries—have rekindled calls for greater diversity of supply across Europe. Developments in the Middle East—especially in Iraq and Iran—and elsewhere in Africa also are lifting world oil prices through increased “security” premiums being sought by producers or traders holding long contracts.

For North American energy consumers, even such far away events indirectly affect energy market prices. In the current environment of razor-thin excess productive capacity margins for both oil and gas, even the slightest market hiccup abroad causes price volatility. For wholesale electricity prices, the run-up has driven up power prices across North America—again.

The warm winter—combined with record high prices—has caused a buildup of gas inventories in storage. The national storage levels as of Feb. 24, 2006, stood at 1,972 Bcf—48 percent above the five-year average of 1,331 Bcf for this time of year (see Figure 1). This level also is more than 2 percent higher than the maximum five-year average of 1,921 Bcf.

Natural-Gas Prices

For our May forecast update, Global Energy used NYMEX futures prices reported April 17-19. Global Energy forecasted Henry Hub prices to average $7.86/MMBtu during May and rise continuously thereafter until January 2007, when they will hit $11.74/MMBtu. The winter-summer differential, defined by Global Energy as the average price of December through February minus the average price from May through October, is $3.17/MMBtu. However, this winter-summer spread is expected to decline as storage inventories rise during the injection season ahead. As of the week ending April 14, national storage inventories stood at 1,761 Bcf, a buildup of 47 Bcf over the previous week’s level. Compared with the five-year average, working gas storage levels still are above historical norms and stand 62.6 percent above the five-year average. Despite the large gas storage levels due to lack of winter-related demand during the 2005-2006 winter season, U.S. gas-directed drilling experienced an increase in rigs used to help meet drilling demand.

Figure 4 shows the historical Henry Hub natural-gas prices, and Global Energy’s forecast monthly Henry Hub natural-gas prices.

During the winter of 2005-2006, Henry Hub spot natural-gas prices continued to trade at extremely high levels compared with most of the history of liquid natural-gas markets. Destroyed deliverability capacity caused by Katrina and Rita during the last quarter of 2005 pushed the market into uncharted territory for part of the winter. More recently, mild winter weather has moderated prices.

At press time, gas prices had returned to a contango (upward sloping futures prices) for the next year; however, prices 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 storage levels. Storage levels at the end of the heating season stood at 1,500 Bcf, a value more than double the previous year’s end-of-season totals. That is, although production had decreased, it was sufficient to meet demand, given available storage.

The production decline from 2001 to 2002 sent a wave through the market. Observers and participants alike began to question the ability to refill storage sufficiently during the 2002 injection season. Exacerbating the market sentiment was the prospect for strong summer cooling demand. Additionally, Canadian exports were at relative low levels, and uncertainty remained around the ability to backfill lost Canadian gas with LNG deliveries.

Natural-gas prices started to decline during the summer of 2002 as it became likely that storage would reach levels considered healthy by the end of the injection season. However, prices did not return to the year’s previous lows of around $2.50/MMBtu. Rather, the price depression halted at roughly $3.00/MMBtu. By September 2002, gas prices were again on the rise, enticed by expectations that hurricane Lili, a Category 4 storm, would disrupt gulf production on the order of 100 Bcf during September and October 2002. Lili made landfall near the central coast of Louisiana.

With uncertainties remaining about lost production and a colder than normal winter, natural-gas prices entered the 2002-2003 heating season at roughly $4.00/MMBtu. Bitterly cold weather in the Northeast caused daily spot prices at the Henry Hub to peak at roughly $19/MMBtu by late February 2003. The cold weather not only was severe but also sustained. The resulting extraordinary heating demand lasted well through March 2003. Higher world oil prices in 2004 and several hurricanes that year contributed to the sustained high prices felt throughout the 2004-2005 winter heating season. Similar things resulted during the winter months of 2005-2006, where prices were high as a result of the production losses caused by hurricanes Katrina and Rita.

Katrina was the most powerful hurricane to hit the Gulf of Mexico in the last 80 years. Shortly thereafter, Rita (also a very powerful Category 4 hurricane) made landfall. The two storms left a great deal of the production in the region shut-in for oil and gas. Leading up to and after the landfall on Aug. 29, 2005, and again on Sept. 21, 2005, respectively, prices climbed to a record high of $12.70/MMBtu on Aug. 30, 2005, and to $14.85/MMBtu on Sept. 23, 2005. Aftermath-related shut-ins continued to reduce gas production in the Gulf of Mexico.

Adding to the mix was the perception that hurricanes Katrina/Rita-related shut-ins could last longer than those of 2004’s hurricane Ivan. However, the price at the Henry Hub and a number of other markets in the Gulf Coast area declined to $8.76/MMBtu by Nov. 7, 2005. The declines were short lived. Fears of a colder-than-normal winter started to rile the market soon after. On Dec. 13, 2005, the price for natural gas at the Henry Hub reached the highest point ever seen, at $15.40/MMBtu, and remained above $14.00/MMBtu for many days.

More recently, as of March 8, 2006, the Minerals Management Service (MMS) reported that 1.4 Bcf/d (or 14 percent of daily production) of natural gas still remained shut-in as a result of hurricane-related damage. However, on this same day, the Henry Hub reported trading natural gas in the $6.50/MMBtu area due to mild weather.

Now a new hurricane season is upon us. With a little luck from Mother Nature, this summer won’t be as traumatic for energy commodity markets.


Forecast Prices at Henry Hub ($/MMBTU):

Sep - 06 8.61
Oct - 06 8.78
Nov - 06 9.96
Dec - 06 11.06
Jan - 07 11.74
Feb - 07 11.70
Mar - 07 11.49
Apr - 07 9.50
May - 07 9.28
Jun - 07 9.32
Jul - 07 9.38
Aug - 07 9.41
Sep - 07 9.43
Oct - 07 9.48
Nov - 07 10.09
Dec - 07 10.68
Jan - 08 11.10
Feb - 08 11.07
Mar - 08 10.80
Apr - 08 8.55