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<title>The Fundamental "Essence" of Natural Gas in Current Markets</title>
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<p align="left"><font face="Arial"><strong><small>About The Author:</small></strong></font></p>
<p align="left"><font face="Arial"><!--webbot bot="HTMLMarkup" startspan --><A name=olsoinfo><!--webbot bot="HTMLMarkup" endspan --></font><font size="2">Joseph
P. Mathew is the President of Hybrid Energy Advisors, Inc. Hybrid Energy
Advisors, Inc., based in Houston, TX, </font><span lang="EN">
<font size="2">provides independent business advisory services to the
natural gas industry and related markets. Their advisory services include
business development, risk management, asset and corporate valuation and
optimization analysis, corporate, project and public finance, general
industry research and analysis, and corporate credit risk analysis.</font></span></p>
<p align="left"><font size="2">For more detail, please visit their website
at
<a href="http://www.hybrid-advisors.com/" style="color: blue; text-decoration: underline; text-underline: single">
www.hybrid-advisors.com</a> or contact Hybrid Energy Advisors, Inc.
directly by e-mail at
<a href="mailto:[email protected]" style="color: blue; text-decoration: underline; text-underline: single">
[email protected]</a> or call 713-666-9007.</font></p>
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<font SIZE="6"><p><b>The Fundamental "Essence" of Natural Gas in Current
Markets<br>
</b></font><b><i>Joseph P. Mathew<br>
President<br>
Hybrid Energy Advisors, Inc</i><span style="font-size: 12.0pt">.</span></b><strong><br>
</strong><font face="Arial" size="2">(<em>originally published by PMA OnLine
Magazine: 2003/01</em>)</font></p>
<p><font FACE="Palatino" SIZE="2"> </p>
</font>
<p class="MsoNormal" style="text-align:justify">The days of confidence in
low, stable natural gas prices, abundant domestic gas supply, and ease of
production in gas-rich reserves among the southern and southwestern United
States and Canada are well over. The only questions that remain are: when
did this happen and what can we expect going forward?</p>
<p class="MsoNormal" style="text-align:justify">The United States has seen
its natural gas prices rise steadily from an average Henry Hub calendar year
price of approximately $2.10/mmbtu in the 1990�s to around $4.00/mmbtu both
in the physical and financial markets today. This latest price phenomenon,
once marveled at as recently as in January 1997 as a price anomaly among the
trading floors of the largest energy merchant firms, seems to be commonplace
when compared to spring 2001 levels of $9-$11/mmbtu. </p>
<p class="MsoNormal" style="text-align:justify">Notwithstanding alleged
corporate malfeasance that led to regional price aberrations, the natural
gas market truly witnessed what inadequate storage management, unpredictable
weather patterns and tightness in supply can do to prices. During this
period, energy firms, utilities and governments felt the brunt of financial
distress, severe cash flow constraints, corporate restructuring and even
bankruptcy. There is no �OPEC� to provide a system of fundamental checks
and balances in this sector. Demand-side management can only provide a
temporary relief to long-term supply shortages with concomitant projected
demand growth. Long-term demand contraction is unhealthy to the economy, of
which energy is a major component. Unless we are prepared to pay over
$1.10/mmbtu more for gas and approximately $8-10/Mwh more for mid-merit and
peak power as compared to the last decade, new sources of gas supply must be
explored and brought to market.</p>
<p class="MsoNormal" style="text-align:justify">Natural gas is clearly the
fuel of choice in the United States, as it is relatively clean burning,
efficient, and more economical than in years past due to improvements in
supply-chain technology. However, the core fundamentals that drive natural
gas prices are relentlessly coaxing upward price expectations. What are
these fundamentals? Mainly, they are weather, transportation fluidity,
storage capacity and supply reliability.</p>
<p class="MsoNormal" style="text-align:justify"><b><u>Weather<br>
</u></b>Weather is a key component in affecting natural gas supply and
demand. In its simplest form, the colder the winter, the higher the gas
consumption rate to heat homes, satisfy industrial processes and fulfill
commercial uses. Similarly, in the summer, the hotter the weather, the
higher the air conditioning needs, thus calling up gas-fired power plants to
handle the additional peak loads. Consequently, upward price pressure can
now be seen in both seasons. This is unfortunate, but weather is a
systematic (non-diversifiable) risk of energy commodities, an affect that
can be partially mitigated by optimal storage management, continued
economical supply procurement and recently developed weather derivative
products. Most weather products are priced using a blend between Black-Scholes
option theory and statistical probability methods similar to those utilized
in the pricing of insurance premiums. Apart from weather patterns, however,
most other areas of natural gas fundamentals are man-made and controlled.</p>
<p class="MsoNormal" style="text-align:justify"><b><u>Transportation<br>
</u></b>The Energy Information Administration (EIA) estimates that there are
over 285,000 miles of interstate gas pipelines within and coming into the
United States and almost one million miles of intrastate local utility
pipelines. Together, these pipelines are delivering approximately 60-70 bcf/day
of supply. Although these types of figures appears comforting and redundant
in its nature to deliver gas from producing regions to consuming regions,
frequent weather-driven demand changes and consumption growth pressures can
lead to congestion at several key delivery points at both ends of the
chain. No area of the country is immune to this event, as we have seen
weather and demand driven prices spike to exorbitant rates in both gas and
power on the West Coast, East Coast and in the Midwest. As in the summer of
1998 and today, companies who do not have the financial strength to sustain
such spikes or who have not properly hedged themselves against these events
can find themselves quickly in the �red� and on their way to Chapter 7 or 11
bankruptcy proceedings.</p>
<p class="MsoNormal" style="text-align:justify"><b><u>Storage<br>
</u></b>Storage, mainly in the form of underground basins, wells, aquifers,
salt caverns, above-ground tanks and subterranean reservoirs, can provide
price buffers and supply �protection� to end users in the sense that risks
associated with exact timing of delivery from producing regions to ultimate
consumption (a form of �just-in-time inventory� risk) can be ostensibly
mitigated.</p>
<p class="MsoNormal" style="text-align:justify">Currently, there is an
estimated 7,000 bcf of total proven base and working gas storage capacity in
the United States. Growth in this capacity is expected to continue as
supply-and demand-related price pressures exist. Figures on net storage
injection (summer months) and withdrawal (winter months) are published
weekly by the EIA (formerly by the American Gas Association) and are eagerly
anticipated by market participants. The domestic gas markets behave
commensurately with expectations of these injection or withdrawal figures,
with prices generally rising with higher than expected withdrawals or lower
than expected injections, and prices generally falling with lower than
expected withdrawals or higher than expected injections, per consumption.</p>
<p class="MsoNormal" style="text-align:justify">The analytical expression of
this relationship is further elucidated when performing a regression
analysis between heating degree days (HDD�s) and cooling degree days (CDD�s)
versus storage levels. One can see that an increase in HDD�s in the winter
months creates more storage withdrawals (therefore creating less net storage
volume), thus creating price support levels (net upward price pressure).
The converse is true in the summer months, when an increase in CDD�s leads
to a greater storage injection (therefore creating more net storage volume),
therefore creating price ceilings (net downward price pressure).</p>
<p class="MsoNormal" style="text-align:justify">Relative to the large
amounts of natural gas produced, transported and ultimately consumed in the
United States market, storage capacity is small. The disparity in current
storage capacity as compared to total consumption will only be exacerbated
with increased gas demand projections. Therefore, short- or long-term
changes in market fundamentals (or combinations of both), such as weather
patterns or gas load growth, can still have a significant affect on prices
going forward.</p>
<p class="MsoNormal" style="text-align:justify"><b><u>Supply and Demand<br>
</u></b>Long-term downstream demand for gas is usually created from an
expected increase in population, regional commercial business growth,
industry growth, and power generation. Thus, the major sources of this
consumption can be broken down into four primary classes: residential,
commercial, industrial and power utilities. </p>
<p class="MsoNormal" style="text-align:justify">One of the larger user
groups of natural gas is power generation entities (such as public
utilities, independent power producers, exempt wholesale generators and
municipal-owned utilities). Currently, one-fifth of electricity production
is fueled by natural gas-fired power plants and approximately 75-80% of
projected new power plants are expected to utilize natural gas-fueled
turbines.</p>
<p class="MsoNormal" style="text-align:justify">Current total United States
consumption is approximately 23,000 bcf per annum. It is expected that
upper East Coast United States consumption due to the growth of these
classes is 2.1 bcf/day (or 767 bcf per annum) over the next several years,
while West Coast United States consumption is expected to grow another 2.0
bcf/day (or 730 bcf per annum) over the next several years. In other words,
almost <i>7% growth</i> in natural gas demand can be attributed to <i>only</i>
two specific areas in the United States. Given the fact that there are now
exists various diseconomies of scale in Gulf Coast, Western Canadian
Sedimentary Basin and mountain states rig production (it takes approximately
2.5 times more active rig capacity to produce the same amount of gas just 8
years ago), new supply sources are required to mitigate continued upward
price momentum. As each marginal gas molecule is more challenging to
procure, higher long-term gas price momentum will be evident despite
improving technologies.</p>
<p class="MsoNormal" style="text-align:justify"><b><u>Conclusions<br>
</u></b>Given the proportionately small amount of storage to provide price
buffers, increasing fundamental demand from the four major gas consumption
classes, unpredictable weather patterns, demand-driven transportation
capacity constraints and the higher unpredictability and marginal cost of
procuring reliable natural gas supply, the United States is going to feel
greater upward gas price pressures, all other things being equal. This
phenomenon reinvigorates natural gas price correlation with crude oil and
distillate products, which serve as a synthetic gas price �proxy� <i>only as
long as substitution is practical and compliant</i> from a regulatory
standpoint (i.e. conformity to Environmental Protection Agency (EPA)
standards).</p>
<p class="MsoNormal" style="text-align:justify">This year, the EIA
anticipated medium-term gas prices to range from $3.25/mmbtu to $3.50/mmbtu
and long-term gas prices to be close to $4.00/mmbtu. In analytically
forecasting natural gas prices (and other price curves, for that matter),
one can assume that the gas price itself is a �dependent� variable
(dependent on the underlying fundamentals that drive the price) and the
underlying fundamentals are the �independent� variables (that influence the
dependent variable).</p>
<p class="MsoNormal" style="text-align:justify">In the spring of 2002,
Hybrid Energy Advisors, Inc. (HEAI), using such analytic techniques,
predicted Henry Hub financial gas prices, the dependent variable, to hold
between $3.35 and $4.10 through the winter months of 2002/2003 (within a 90%
confidence interval). They also estimate ten-year price forecasts of
$2.25-$2.80/mmbtu during the summer months and $3.70-$4.25/mmbtu during the
winter months (also within a 90% confidence interval). These estimates
utilize stochastic price forecasting methods with the aforementioned natural
gas fundamentals serving as the independent variables. HEAI believes that
ten-year city gate prices of gas on the West Coast and Midwest United States
will trade approximately equivalent (�flat�) to Henry Hub prices. Similarly,
they expect upper East Coast prices to trade at an approximate 45-65 basis
point (cents/mmbtu) premium to Henry Hub prices.</p>
<p class="MsoNormal" style="text-align:justify">Many of these forecasts
include a greater gas import as a percentage of total domestic gas supply
assumption, but opinions vary on how much this percentage is and what
expectations are in the future concerning supply reliability, technology,
regulations, legislation and other market risks.</p>
<p class="MsoNormal" style="text-align:justify">Some of the explorative new
gas sources currently being considered are:</p>
<ul style="margin-top: 0in; margin-bottom: 0in" type="disc">
<li class="MsoNormal" style="text-align: justify"><font face="Arial">
continued deep-water Gulf Coast exploration (which several of the major
energy giants having allocated multi- billion dollar capital expenditure
budgets to this cause during the next decade) using 3D seismic technology,
deep- and lateral-drilling technology,<br>
</font></li>
<li class="MsoNormal" style="text-align: justify"><font face="Arial">
continued exploration and development in and around the Western Canadian
Sedimentary Basin to add to its current 9.5 bcf/day gas import load,<br>
</font></li>
<li class="MsoNormal" style="text-align: justify"><font face="Arial">
Arctic gas, such as major proven gas reserves in the hotly debated Arctic
National Wildlife Refuge and Prudhoe Bay region of Alaska,<br>
</font></li>
<li class="MsoNormal" style="text-align: justify"><font face="Arial">the
MacKenzie Delta in northwest Canada, and<br>
</font></li>
<li class="MsoNormal" style="text-align: justify"><font face="Arial">
liquefied natural gas supplied from Europe, Asia/Pacific Rim, South
America, Trinidad & Tobago, Africa, the Middle East and the United States
(Alaska). HEAI believes that by the year 2010, approximately 6-8% of the
total US gas supply will come from LNG produced from foreign stranded gas
reserves, as compared to its 1% contribution to domestic supply today.</font></li>
</ul>
<p class="MsoNormal" style="text-align:justify">Although there is quite a
bit of merit to each of these gas supply sources, any and every new supply
source may be more costly than previously seen. Therefore new gas projects
will be dependent on marginal gas pricing scenarios that are substantially
higher than the historic nominal ten-year average. As pricing discovery
increases and continued research on the economic viability of this new gas
source �supply stack� continues, where the next gas molecule comes from and
what its impact will be on market prices are a major subject of debate in
the industry.</p>
<p class="MsoNormal" style="text-align:justify">Market participants need to
be as fully informed and abreast of the nature of these sources, who is
participating in bringing this gas to market, and what the economic
valuation and cost of these projects are compared to the prices in the
market that will sustain them. Combinations of this new gas supply,
technology improvements, storage management, transportation optimization,
demand-side management and weather risk management all play a major role in
gas market stability going forward. In the end, there is no simple solution
to mitigating upward gas price pressure, but indeed there is a solution.</p>
<hr color="#FFFF00">
<blockquote>
<p align="left"><font face="Arial"><!--webbot bot="HTMLMarkup" startspan --><A name=olsoinfo><!--webbot bot="HTMLMarkup" endspan --></font>Joseph
P. Mathew is the President of Hybrid Energy Advisors, Inc. Hybrid Energy
Advisors, Inc., based in Houston, TX, <span lang="EN">provides independent
business advisory services to the natural gas industry and related
markets. Their advisory services include business development, risk
management, asset and corporate valuation and optimization analysis,
corporate, project and public finance, general industry research and
analysis, and corporate credit risk analysis.</span></p>
<p align="left">For more detail, please visit their website at
<a href="http://www.hybrid-advisors.com/" style="color: blue; text-decoration: underline; text-underline: single">
www.hybrid-advisors.com</a> or contact Hybrid Energy Advisors, Inc.
directly by e-mail at
<a href="mailto:[email protected]" style="color: blue; text-decoration: underline; text-underline: single">
[email protected]</a> or call 713-666-9007.</p>
</blockquote>
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