By Abbas Chagani

The recent increased volatility and relatively high natural gas prices are causing some concern amongst energy users. The concern is primarily driven by the cash flow risk associated with higher prices. Figure 1 shows the changes in 2007 and 2008 forward prices over the last 6 months. It shows that fixed prices for the one year term have not only increased but the fluctuations have also increased. Under these conditions, when prices and volatility are high, hedging decisions become even more critical.

The supply factors that affect the price of natural gas include; the price of crude oil, inventory levels, production changes, and liquefied natural gas (LNG) imports. On the other side, the demand factors that affect prices are current economic conditions, short term weather, and electricity generation.

Figure 1: Forward natural gas prices at AECO

Factors that drive the price of Natural Gas up

Crude Oil
Historically, the price of natural gas correlates with the price of crude oil. This is the result of a substitution effect, where users will substitute the cheaper of the two fuels and force prices to equilibrium. Thus, the factors that influence crude oil also influence natural gas.

The US Energy Information Administration (EIA) forecasts global crude oil demand to increase in 2008 by 1.2 million barrels/day (or 1.4%). The recent downward revision (from 1.3 million barrels/day to1.2 million barrels/day) is driven by the expected decline in global economic growth, primarily in the US and less so in Western Europe . By contrast, growth in emerging and developing countries is expected to ease modestly but remain robust in 2008. These emerging and developing countries, including China, India and the Middle East, account for most of the expected growth in crude oil demand.

Crude oil is generally priced is US dollars and while the dollar has been declining, the price of crude has been steadily increasing. Figure 2 displays the inverse relationship between the price of crude oil and the value of the US dollar against the Canadian dollar. These factors, partnered with uncertainty regarding possible disruptions in global supply, have caused the price of crude oil to trade close to 115 US $/barrel, reaching an all time high on April 21 at 117.40S $/barrel.

Figure 2: Crude Oil (US$/Barrel) vs. US $ value

Natural Gas Inventories
The EIA estimates that US natural gas inventory was 1,261 billions of cubic feet (bcf) on April 11th, this is 298 bcf (or 19%) below last year and 3 bcf (or 0.2%) below the 5 year average. An additional 1.7 bcf/day will have to be injected into storage in order to bring natural gas inventories back to acceptable levels before next winter.

Factors that drive price of Natural Gas down

North American Economy
The IMF forecast the US tipping into a mild recession in 2008 as a result of reinforcing cycles in the housing and financial markets, before starting a modest recovery in 2009. The economic conditions should limit the growth in the demand for natural gas. In, 2009 natural gas demand in the US is projected to decrease slightly in the commercial and residential sectors, with a modest increase in the industrial sector. Higher gas prices and a mild recession should put downward pressure on prices.

Increased gas production in the US
Total US gas production is expected to increase by 2.9 %, lead by a 4.8 % increase in deepwater supplies in the Gulf of Mexico. The recent development at the independence hub in the Gulf of Mexico, where a gas leakage in an adjacent pipeline has shut production down, should be repaired in the next few weeks. Production in the lower 48 states is expected to increase by 2.9 %, lead by the growth in the unconventional production basins. Increased gas production in the US should help alleviate pressure on prices.

Factors that increase volatility and drive uncertainty

Value of Canadian dollar
The value of the Canadian dollar has been steadily rising over the last five years. Figure 2, shows the transition in 2007, where the dollar went from 0.85 $US/$CDN in January to its all time high of 1.07 $US/$CDN in November. The Loonie currently trades at 1.02 $CDN/$US, and some analysts feel that this is still not the value justified by relative purchasing power parity. There is also uncertainty regarding the interest rates as determined by the US Federal Reserve and the Bank of Canada. The key factor to consider, with respect to the value of the Canadian dollar, is that for every 1 cent decrease against the US dollar, the price of gas increases by 8 cents per GJ.

LNG coming into the US
The EIA forecast that imports for LNG will reach 680 bcf in 2008. This represents 12% less than the record volume imported in 2007. Strong demand in Asia and Western Europe, which compete with the US for LNG, has considerably reduced the number of US bound LNG cargoes so far this year. It is expected that US imports should increase during the summer as the demand in Europe and Asia soften. The question is whether LNG imported into US during the summer will be comparable to last year’s volume and, along with domestic production, will be adequate to fill reserves.

Short Term Weather
Many times price fluctuations are often a consequence of short term weather effects. In the winter time, colder than normal weather increases the demand for natural gas for heating purposes. Whereas, in the summer time, warmer than normal temperatures increase the demand for natural gas as it is used for peak electricity generation. Temperatures for the upcoming summer period in the US and Canada will continue to have a significant impact on gas demand. Additionally, the Colorado State University forecast team also upgraded its early season forecast this month, saying the U.S. Atlantic basin will likely experience a well above-average hurricane season, which could impact natural gas producers in the region and further contribute to volatility in demand.¹ However, hurricane forecasting is far from being an exact science and they have been wrong in the past. But often just the thought of a hurricane is enough to cause turmoil in the natural gas market.

Conclusion
This combination of supply and demand factors influencing natural gas prices have meant relatively high natural gas prices and increased volatility over recent months. This pattern seems set to continue as we approach summer. For this reason, it is imperative that natural gas users seek expert sound advice before making critical hedging decisions.

¹http://hurricane.atmos.colostate.edu/