The beginning of a new year brings strategy discussions and forecasts for stock price winners. In energy, some level of a recovery in crude oil prices is required for a recovery in the TSX energy indices, given the relative index weight of oil-oriented companies. However, picking stock winners may be easier among natural gas stocks since many signposts are made in North America, unlike the global conditions bearing on crude oil.
A recovery in crude oil prices is directly and wholly dependent on OPEC balancing world crude markets by reducing OPEC supply. The balancing act will be affected by non-OPEC supply impacts and on world economic activity, though primarily among OECD and major Asian countries. But only OPEC can make production changes in timing and quantity that will short-cut the length and depth of the global recession.
The North American natural gas market is different. Except for a small quantity of LNG imports, and primarily during the summer, more than 90% of consumption is supplied within North America. The economic recession and demand destruction, such as the closing of industrial plants, is causing a decline in consumption. In the absence of a supply response, an economic recovery would be needed to balance the market.
Fortunately, natural gas supply is very price elastic and production rates decline much faster for new gas wells than for oil wells. Natural gas wells lose 30% or more of their production capacity after the first year and more than 50% after two years. Up to 50% of North American gas production comes from wells drilled during just the past five years. Total industry production capability from existing wells declines by an average of more than 20% per year. In the absence of a sufficient quantity of new wells being drilled, supply goes down. Thus, analysis of supply activity, that is drilling rig activity, provides a significant leading indicator of supply response.
In Canada, new supply has been impacted in 2007 and 2008 and it will worsen in 2009. Factors have included the rise of the Canadian dollar, which devalues the Canadian wellhead price; weak U.S. gas prices in 2007 and early 2008; and the Alberta royalty changes, in which the process began in early 2007 and several changes have occurred even before implementation on Jan. 1.
Canadian drilling activity peaked in 2005 with nearly 25,000 holes drilled. It has fallen each year since, with about 17,000 holes in 2008 and possibly fewer than 15,000 in 2009. Predictably, Canadian natural gas production has been falling since 2005. However, Canada contributes only one-fifth of North American production and, while it exports more than 50% of its production, these exports are only 15% of U.S. consumption. So the bigger picture on supply response is drilling activity in the United States.
Unlike the trend in Canada, U.S. rig activity had a cyclical low of 800 in 2002 and then grew every year until the peak of over 2,000 rigs in mid-2008. The number of rigs drilling onshore for natural gas peaked at about 1,600. A senior Canadian company that is active in the U.S. forecasts that the U.S. rig count for land-based natural gas drilling needs to fall to 1,000 for excess natural gas supply to be eliminated. With the recent such count just below 1,400 rigs, activity has a long way to go. Moreover, the decline needs to happen quickly to avoid having a record amount of natural gas remaining in storage when the injection season begins in April.
Wilf Gobert is an independent energy analyst based in Calgary and a senior fellow with the Fraser Institute.
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