In recent weeks, the emerging natural gas (NG) supply problem in the United States has been well documented by a steady stream of commentators including Andrew Weissman of Energy Ventures, Ellen Hannan at Bear Stearns and, perhaps most convincingly, Matt Simmons at Simmons International. These analysts have noted several crucial issues: (1) U.S. NG inventories are at some of the lowest levels in over a decade with only 990 bcf in storage compared to 1775 bcf last year and a five year average of 1,520 bcfpd. (2) U.S. NG production has steadily declined in recent years from 52.1 bcfpd in 1998 to 48 bcfpd in 2003 and is projected to drop to 44.3 bcfpd by 2007. (3) Despite this erosion of production, the United States has installed upwards of 220,000 MW of NG fired electric generation capacity in the last several years and continues to add more almost weekly. In just the last month alone, for example, Mirant began commercial operation of its 533 MW NG plant near Las Vegas and Tampa Electric began operation of its 750 MW Bayside 1 NG unit while announcing Bayside 2 (1,000 MW) will begin operation in January. The Bayside facilities replace the retiring Gannon coal plant – thus, a net increase of NG usage.
And the beat goes on. Keyspan just announced its plan to build a NG power plant on Long Island next year and Exelon is completing an 800 MW NG unit at Fore River in Massachusetts as well as the twin 800 MW NG units Mystic 8 and 9 – both replacing oil plants. In fact, over 11,000 MW of new NG fired turbines will come on line this summer in 16 new plants located in the Northeast and West alone. The continuing addition of these NG fired turbines to the generation mix means NG will have to meet virtually all incremental electricity demand as well as make up for shortfalls from other generation sources (e.g. unexpected nuclear outages such as the recent event at the 1,250 MW South Texas Project 1 unit).
The cumulative nature of the three issues delineated above has profound implications for the U.S. economy and our quality of life. We have built an entire infrastructure – electric generation, residential heating, manufacturing and commercial development – on the assumption that NG would be available at a relatively moderate cost for the foreseeable future. This assumption will surely be put to the most severe of tests as early as this year.
The emerging NG supply problem has not gone unnoticed in Washington. Earlier this year, President Bush indicated concern at NG shortages could impede economic recovery. In testimony before the Joint Economic Committee, Federal Reserve Chair Alan Greenspan stated the low level of NG supplies is “a very serious problem” and indicated he is “quite surprised at how little attention the natural gas problem has been getting”. And earlier this month, Spencer Abraham, Secretary of Energy, called for a special June meeting of the National Petroleum Council to “identify those actions which can be taken immediately to ease short-term supply constraints”. While a reasonable skeptic would ask “Why wait until June?” there is little doubt Abraham will find his options quite limited in terms of supply.
Basically, the United States has three sources of NG supply: (a) land and offshore production in the lower 48 (81%), (b) imports from Canada (17%) and (c) imports of LNG (2%). In separate reports Weissman and Simmons have already documented the difficulty of increasing supply from within the continental U.S. and offshore. Numerous commentators have acknowledged that significant supplies of LNG is years away due to lack of infrastructure, the long lead times needed and national security risks. This leaves Canada – the focus of the present analysis – and a not too comforting picture.
Can Canada Help? – Probably Not
Canada is the largest supplier of energy to the United States. In 2001, for example, we imported about 500 MMbbl of oil and 3.8 Trillion Cubic Feel (tcf) of NG from our northern neighbor. We are also a net importer of electricity to the tune of 25,000 GWH most years and up to 35,000 GWH when needed.
Further, since U.S. NG production has declined steadily in recent years we have increasingly relied on Canadian imports to meet growing demand. In 1998, for example, we imported 8.4 bcfpd from Canada but by 2001 that figure had climbed to 9.7 bcfpd. Currently, it is estimated Canada supplies about 17% of U.S. natural gas supply.
In fact, U.S. NG policy is predicated on stable increases in Canadian imports over the next several decades. In 2000 the National Petroleum Council concluded “U.S. gas demand will be filled…with increasing volumes from Canada”. The next year the Energy Information Administration (EIA) predicted imports of NG from Canada would increase substantially over the next decade and stated “Canadian resources are adequate to sustain production for many years”.
Unfortunately, recent months have shown that Canada is very unlikely to significantly increase NG exports to the United States. Thomas Driscoll at Lehman Brothers has studied this issue extensively and has projected that the 9.7 bcfpd imported in 2001 may be the high water mark for quite some time. Driscoll estimates 2003 imports at 9.1 bcfpd, 2005 at 9.3 bcfpd and 2007 at 9.5 bcfpd. Such numbers clearly are not what the NPC and EIA had in mind just a few years ago when predicting an ever expanding supply of NG from Canadian fields.
Yet it would be unfair to say that Washington types were the only ones overestimating Canadian NG production – the market was fooled as well. As a testament to these great NG expectations money was poured into pipelines destined to bring Canadian NG to the burgeoning U.S. metropolitan centers. The most heralded of these, Alliance Pipeline, was announced in the late 1990’s as the means to ship as much as 1.3 bcfpd from NG laden British Columbia to what is arguably the city most dependent on NG – Chicago. In fact, newspaper headlines at the time were typified by the Houston Chronicle in May of 1997, “Natural Gas poised to flood into U.S.”.
After five years of planning and construction, many delays and much fanfare, Alliance came on stream at a cost of over $4.5 billion. Its subsequent impact has been minimal and the only significant consequence of Alliance is that it takes NG that had previously been transported by smaller pipelines – putting them in financial disarray. Supply has not been increased leaving the question: “Canada has the pipelines but does it have the gas”?
While estimating the future production of Canadian NG is a complex matter it is safe to say that at least six factors are converging to constrain NG exports to the United States over at least the next five years:
- Low NG inventory – just as the United States is facing near historic lows in storage levels so is its major supplier of NG. Generally speaking, Canadian inventory at the end of the injection season (November) should run about 450 bcf. Earlier in May, however, it was reported that storage was only 117 bcf – compared to 264 last year and a five-year average of 211. Clearly, Canada will have a difficult time meeting its own needs let alone bailing the U.S. out of a supply shortage.
- Declining production – Matt Simmons has made “depletion” a household world in the energy investing business by pointing out the accelerating decline rates of the U.S. wells is over 40% the first year. But this phenomenon is not limited to the United States. Canada also faces a serious depletion problem of at least 30% which can be likened to a treadmill – running even faster just keeps one in the same place.
Perhaps no better depiction of the treadmill analogy can be drawn than in Lehman Brother’s estimate:
In essence, after the drilling of over a hundred thousand wells in the decade 1998 – 2007 Canadian NG production will be basically the same in 2007 as it was in 1998.
In fact, if it weren’t for one single field – Ladyfern – in northeastern British Columbia, the 2001 increases probably wouldn’t have occurred. Ladyfern was originally billed by Premier Gordon Campbell as “the largest discovery in the last 15 years in Canada.” Talk of a million bcf “Elephant” was rampant. And, for a time the promise was fulfilled as production from Ladyfern swelled Canadian supplies. Unfortunately, Ladyfern is susceptible to substantial decline rates and the Canadian National Energy Board (NEB) has estimated its decline to be at least 63% over the 2003-04 period. Clearly Ladyfern will not be much of a factor by the end of next year – a major reason Canadian production is projected to revert back to 1998 levels.
- Shallow Field Focus – In December of 2002, the NEB provided a dose of cold water to conventional thinking regarding future NG supply. In their “Short-Term Natural Gas Deliverability” assessment of the Western Canada Sedimentary Basin (WCSB), NEB concluded:
“Despite drilling a record number of gas wells in 2001, and the start up of the highly productive Ladyfern project, increases in natural gas deliverability have been lower than projected…”
The NEB attributes these shortfalls to not only the aforementioned decline rates but also to the “tendencies toward drilling in shallow gas areas characterized by low productions per connection”.
In other words, producers have focussed on shallow gas plays which (a) are inherently smaller than their deeper counterparts and (b) have higher decline rates. As a result, more and more wells have to be drilled for less and less payoff. In 2003, for example, a record 11,350 new gas wells are projected across Canada – yet production is expected to decrease. The NEB estimates that fully 67% of all 2001 well connections in the WCSB occurred in shallow gas plays. Until Canadian producers make a systematic effort to access the deeper fields there can be little expectation that NG production in the WCSB – historically Canada’s most prolific region – will increase. Rather, WCSB has appeared to have reached a plateau – more wells, lower production.
- Remote Reserves – Canada is blessed with tremendous oil and gas reserves. The NEB estimates there are at least 555 tcf of NG remaining in the nation. Unfortunately, many of these reserves are in what are remote or difficult to reach areas including (a) Northwest territories (175 tcf), (b) offshore including deepwater (167 tcf), and (c) the more inaccessible areas of Alberta and British Columbia.
Access to these reserves is years, in some cases decades, away. Significant infrastructure must be built. Pipelines would have to be put in place at a cost of billions of dollars. Foothills Pipeline Company, for example, says a 2,700 km NG line through Canada’s Yukon and into Alberta where it would connect with existing lines would cost over $6 billion. Further, the First Nation residents of the region would have to approve the project. While the MacKenzie Delta will one day be an important source of NG this timeframe is far beyond the help needed by the U.S. over the next five years.
- Opposition to exports – As the Canadian public becomes more aware of the NG situation, look for opposition to exports increase dramatically. The price increases in NG are not confined to the U.S. but impact Canadian consumers as well. There will be little support to ship this commodity south just because the U.S. has a shortfall and will pay higher prices. Price spikes next winter could create a public backlash which would overwhelm free trade politicians.
Canada has a “market oriented” trade policy relating to NG based on the 1985 Western Accord on Energy. But this policy may be sorely tested as high prices and demand for NG by consumers force a rethinking of the current liberal approach. In fact, problems have already begun to surface:
Ken Vollman, Chair of the NEB says most Canadians favor free trade in theory, but that support will evaporate amidst high heating bills.
How all this plays out within NAFTA is still open to question. One interpretation is that the current agreement guarantees the U.S. 60% of Canadian NG. Needless to say, with declining Canadian production and rising U.S. appetites Canadian proponents of NAFTA may soon be between a rock and a hard place.
- In March, the New Brunswick government filed an appeal to block dedication of a pipeline designed to send NG from offshore Nova Scotia to Boston and other areas of the northeastern United States. The New Brunswick appeal argued sending Scotian NG to the U.S. will not allow for the needs of Canadians’ to be satisfied.
- In Calgary, the Citizens’ Oil and Gas Council intervened in an NEB case regarding a plan by ProGas to export NG directly to a food-processing plant in North Dakota. The Council argued that Canada is “exporting too much gas and not leaving enough for Canadian consumers”.
- Unions are getting involved as well. The Communications, Energy and Paperworkers of Canada has stated:
“We will intervene in NEB hearings to ensure that we consider our long term needs, and so that Canadian natural gas will be affordable for our key industries…”
- Demand in Canada – the U.S. is not the only North American country in which NG has emerged as a preferred fuel. Canada is also increasingly dependent upon the fuel. Canada exports about 60% of its NG but native demand is steadily increasing along at least three fronts.
- Power generation – like the U.S., Canada has built NG facilities to meet growing demand for electricity. The NEB has stated “Combined-cycle gas technology, located close to load centers, appears to be the preferred option for new generation” (e.g. the 578 MW Brighton Beach 2004 unit in Ontario).
Further, given Canada’s nuclear problems the pressure on NG facilities may well increase. The restart of Pickering A has been delayed numerous times as has the restart of the twin 750 MW Bruce reactors. All three of these plants are now delayed again and restart dates uncertain. Numerous commentators have pointed out that unless these three major nuclear units are online this summer, the pressure on NG supply could be immense.
- Organic demand for NG is increasing as Canada’s economic recovery continues. NG for manufacturing and commercial growth is an important component to the future expansion of the Canadian economy. Certainly the chemical industry will be pushing to keep lower priced NG in Canada in order to gain competitive advantage over their U.S. counterparts.
- Oil Sands development in Alberta has long been seen as a future economic boon to the region. In this process tar-like bitumen is transformed to crude oil. Paul Cellucci, U.S. Ambassador to Canada, has indicated the U.S. hopes to import up to 2 million barrels of oil per day from the oil sands fields. Suncor Energy is the primary actor in the oil sands operation and they have shown growing concern about the availability of the NG needed to loosen the bitumen from the soil. The heat intensive nature of this process should not be underestimated. Geologist Joe Riva (Library of Congress) has estimated about 20% of Canada’s annual NG production (i.e. 1.3 tcf) will be needed to operate Alberta’s oil sands projects. In short, Canada faces a major trade-off between continuing oil sands development and producing NG for local consumption – and export. This economic and political debate will become increasingly strident as the public becomes aware of the implications.
It is increasingly clear the U.S. is facing an emerging NG supply problem stemming from declining production and increased demand – especially in the power generation sector. Although Canada has effectively served as the marginal supplier of NG over the past several years, the U.S. cannot expect expanding supply from the North since Canada faces its own difficulties. In addition, LNG imports from overseas will not significantly increase for years. Finally, Mexico imports NG and the amount imported from the U.S. will soon reach 1 bcfpd.
Perhaps as early as the summer, the U.S. will face significant price spikes to destroy NG demand and allow for local gas distribution companies to fill storage for the winter. Prices are already at work to destroy demand, at the NYMEX HH the close on May 29, 2001 was $3.71 mcf and for May 29, 2002 it was $3.42. This week the price will close around $6. No one fully understands the implications of this situation since our infrastructure is based upon the assumption NG will be readily available at a reasonable price. We do know NG supply problems in the 1970’s caused severe socio-economic disruption. Even then, however, our nation was not as dependent on NG for power generation and residential and commercial space heating. These infrastructural changes are not fully recognized on either Wall Street or Main Street.
To a large extent the snap cycle of 2001 portrayed a spurious picture of how easy it is to solve a NG problem. Prices spiked to $10 but drilling ramped up, well operators moved to “flush” production, Canada sent more NG and soon storage facilities were brimming. In the meantime, however, one of the warmest winters in history and a cool summer occurred, terrorists attacked the WTC and the Pentagon and the nation was mired in recession. There is no reason to expect a similar confluence of events and the relentless process of well depletion marches on in both the U.S. and Canada. Surely, we live in interesting times.