Natural Gas Is Likely to Stay Pricey

By RUSSELL GOLD
Staff Reporter of THE WALL STREET JOURNAL
June 14, 2004; Page A2

While crude-oil prices are calming down, natural-gas prices in the U.S. are poised to stay strong. And unlike with oil, there are no big natural-gas producers to step up and fix the problem.

The economic recovery and proliferation of natural-gas-fired power plants continue to rev up demand for the fuel. But energy companies aren't keeping up. In fact, they are struggling just to maintain supplies, which may make natural gas vulnerable to an unprecedented summertime price increase in coming months.

Natural gas -- used for industry, home heating and for the generation of electricity -- is expected to remain pricey for the next year. It has cost more than $5.50 a million British thermal units nearly all year, and last month, traders on the New York Mercantile Exchange bid up contracts for the next 12 months to an average price of $6.75 a million British thermal units, a record. Though both near- and long-term prices have retreated along with crude oil, they still remain high.

Oil prices began to come down after the Organization of Petroleum Exporting Countries this month pledged to increase production in order to curb crude-oil prices. Saudi Arabia, OPEC's most powerful player, has about a quarter of the world's oil reserves and hasn't begun to tap them all.

Natural-gas producers can't drill their way out of their problem. North America natural-gas reserves have been slowly declining since the 1980s, and the low-hanging fruit has been plucked. Importing natural gas is difficult, in part because only a limited number of terminals can accept gas that is super-cooled to be transported.

Instead, the biggest natural-gas producers in the U.S. are mostly rearranging the furniture -- buying each other to get at prized reserves in the Rocky Mountains rather than spending their cash on new prospects. In a different tack, Anadarko Petroleum Corp. last week said it would sell a quarter of its producing properties in North America, putting them in the hands of smaller companies with less financial ability to rejuvenate aging fields. Meanwhile, Anadarko plans to redeploy much of its efforts into faster-growing, more promising regions overseas.

Currently, more than 1,000 rigs are drilling for natural gas in the U.S., close to the 2001 high, and about another 200 are active in Canada, according to Baker Hughes Inc., which has been tracking natural-gas rigs since 1987. But even those that want to increase activity to capitalize on high commodity prices are finding the raw materials aren't necessarily available.

"What we see currently and what we see over the horizon in the next year or two is at best in North America a flat-supply scenario," says Darryl Smette, a senior vice president at Devon Energy Corp., of Oklahoma City, the largest U.S. independent producer of natural gas. "Over the past three or four years, the wells we are drilling in North America have tended to find fewer reserves with greater declines when those reserves start producing."

Overall, reservoirs in North America tend to be inferior and smaller, driving up the cost of production, says Steven Shapiro, executive vice president of Burlington Resources Inc., of Houston. "The rig count is fairly high, but the productivity that we're seeing out of those rigs is not as high."

However, with higher prices, companies now are focusing on fields that once were passed over because costs were too high. Burlington Resources, for instance, is developing new reserves in central Wyoming's Madden Field. The gas is nearly five-miles deep, twice as deep as conventional wells, and under extraordinary pressure. Drilling so far down can take nine months and requires specialized services to make sure the pressure doesn't blow out the pipe.

The result of these trickier wells, in Madden and elsewhere, is that the search for natural gas in North America has become markedly more expensive. From 2001 through 2003, the three-year average finding cost for natural gas was $1.53 a million BTUs, up 29% from the three-year average the year before, according to a recent analysis by Bear Stearns. Costs are continuing to rise: In 2003, the average finding cost was $1.73 a million BTUs.

With new gas so hard to find and so costly, companies that want to show growth are prospecting on Wall Street. In April, Kerr-McGee Corp., of Oklahoma City, spent $2.5 billion to purchase Westport Resources Corp., the first of three comparably sized deals that included EnCanaCorp., of Calgary, Alberta, acquiring Tom Brown Inc. The trend continued last week when Petro-Canada, of Calgary, snapped up Prima Energy Corp. for $534 million. Part of the reason behind the recent spate of acquisitions is that it is cheaper to buy known reserves of natural gas than it is to explore for new ones.

But by pouring cash into acquisitions, energy producers are merely swapping reserves, not adding new reserves. Bear Stearns analyst Ellen K. Hannan noted in a recent report that in 2001, the last time more than 1,000 rigs were drilling for natural gas in the U.S., companies replaced 97% of the reserves they took out of the ground with new finds, essentially keeping the cupboard stocked for future years. In 2003, companies replaced 84% of the reserves they took out of the ground.

The largest producers of natural gas in the U.S. -- such as BP PLC of the United Kingdom, Exxon Mobil Corp., of Irving, Texas, and ChevronTexaco Corp., of San Ramon, Calif. -- found new gas to replace only 52% of the gas they extracted. "These results should be of major concern for consumers of natural gas," Ms. Hannan said.

That concern applies to the long term as well as this summer. A warmer-than-usual summer would tax supplies as natural-gas-fueled power plants are started up to keep air conditioners humming. "The terrifying thing is if we have a hot summer," says Robert Esser, a senior consultant at Cambridge Energy Research Associates, "you could have summer [price] spikes." The underlying reason, he says, is growing demand and flat supply. In 2001 and 2003, cold weather led to extraordinary price increases in the winter, when natural gas surged past $10 a million BTUs, but there haven't been such extreme summer price increases before.

A supply crunch during the summer could quickly erase the healthy amount of natural gas being injected into underground storage reservoirs for the winter. Current storage inventory is average for this time of year and in much better shape than a year ago, when low injection rates in the early summer spooked traders and pushed up prices.

Meanwhile, the power-generation industry's natural-gas demand is up 4% from last year and is expected to continue growing. "The underlying demand coming from the power sector is such that you are always going to be strained to meet that demand on the supply side," says Stephen Brink, director of fundamental analysis for EnCana, a Calgary company that is one of the largest North American energy producers.

Write to Russell Gold at russell.gold@wsj.com