Providing coverage of Alaska and northern Canada's oil and gas industry
October 2006

Vol. 11, No. 42 Week of October 15, 2006

Two ANS gas nightmares: LNG, coal

ConocoPhillips’ chief economist, Marianne Kah, sees gas line threat from two directions: plentiful LNG, switch to coal

Kristen Nelson

Petroleum News

There is a window for Alaska North Slope natural gas and Marianne Kah, ConocoPhillips’ Houston-based chief economist, has both supply and demand nightmares about how it could close: ANS gas could lose the market to a plentiful supply of liquefied natural gas from abroad; or it could lose the market to demand destruction caused by utilities in the Lower 48 building coal-burning plants.

Kah told the International Association for Energy Economics in Anchorage Oct. 10 that she also sees a purely Alaskan threat: the gas reserves’ tax initiative on the November ballot which would slam a $1 billion a year tax on North Slope natural gas in the Prudhoe Bay and Point Thomson fields, delaying the gas pipeline and also putting a damper on investment in the state.

Natural gas prices

Kah said that over the course of 12 months natural gas prices have been at $15 and at $4; and when the price was $15, the forward-looking price was $11. That forward curve was inflated by financial investors, she said, but why is the price dropping?

Inventories are high right now, and “there is still concern that we will reach storage capacity,” particularly if the winter is warm. If inventories fill up, prices could drop lower, she said, using the United Kingdom as an example.

The UK gas market had been extremely tight, but after the Langeled pipeline came on from the North Sea at the beginning of October “gas prices went negative” and gas had to be shut in because storage was full and there was no place to put the gas, Kah said.

“So we have seen the ugliness of what could happen with too much supply and we just hope that doesn’t happen in the U.S.,” although several companies have shut in U.S. gas production because costs are so high.

Domestic gas production is flat, not declining — partly because of production returning after the hurricanes — but Kah said it also shows “we are getting a much bigger supply response at these higher prices we’ve seen than I expected … a higher supply response than a lot of people thought was possible in the Lower 48, which worries me long term.”

Department of Energy forecasts for demand and Lower 48 production show that new gas supplies will be needed, which is why ConocoPhillips is interested in building a gas pipeline from the Alaska North Slope, she said.

The 20 years of gas bubble is gone; it went away in the mid-2000s; and with combined-cycle power technology the power sector is using more natural gas and the gas-intensive portion of the industrial sector, fertilizer and aluminum, is being driven out of the U.S. “They just simply can’t be here. They were developed here at $2 to $3 gas environment and really can’t live in an environment of gas prices above that. And they will move to places like Trinidad that have stranded gas and will not remain in the United States,” she said.

Growth in electric power sector

Kah said the electric power sector is where there is likely to be the most domestic growth in natural gas use.

“And I would say for the next five years that demand growth is built-in: we don’t have to worry about that. Those power plants have already been built and they’ve been running at 25-40 percent utilization rates … (and) we’ll probably run those power plants at higher capacity rates before anyone will build new power plants.”

Kah said she is “very worried” about what happens in 2010-12.

“If people don’t see our pipeline coming (from the Alaska North Slope), they will build coal plants and they will build nuclear plants and at any price that gas demand won’t be there,” she said.

The power companies need to see that the gas pipeline is coming, “they need to believe the project’s real, they need to believe it’s going to happen or we will see that gas demand disappear.”

The U.S. Department of Energy has forecast that coal is going to gain share in the power sector, from 50 percent to 57 percent, she said. Natural gas is projected to lose share, dropping from 19 percent to 17 percent. DOE is also projecting that nuclear will lose share, but Kah said she thinks the incentives for nuclear in the Energy Policy Act of 2005 will help that industry grow.

“So I worry about nuclear taking share away from gas.

“But my biggest worry is coal-fired power plants, because right now, utilities are trying to decide what to build going forward.”

The Midwest and other regions are going to have to decide over the next five or 10 years what kind of power plants to build “and they’re going to go for coal if they don’t see that pipeline coming.”

In Texas, traditionally a gas-burning state, with 70 percent of its power coming from natural gas, the big utility in Dallas is permitting eight coal-fired power plants and another utility in the state is trying to permit a nuclear power plant.

“I’m very worried about this. That market won’t be there if we don’t make it clear that pipeline’s coming to them.”

Alaska production is a huge part of the potential growth for U.S. natural gas, but “if we don’t get that Alaskan production, we will have lower demand growth,” she said, stressing that “timing is an issue here. … We could make the investment (in the gas pipeline) and lose the market if we’re not careful and I spend a lot of my time talking to utilities, trying to tell them that the pipeline is coming.”

LNG supply likely to grow

Kah said there is a lot of confusion about LNG, but through 2010 the supply “is extremely short. There really are no extra cargoes,” and what few extra cargoes there are, are taken by regulated utilities in Japan and Spain that can roll the price into average costs.

“But post 2010 … there is a big potential for an oversupply of LNG,” she said. “And what we expect to see is gas-to-gas competition taking place then as LNG projects compete to get into the market and compete for long-term contracts.”

“That’s my second nightmare … (the) first is coal plants, second is LNG.”

ConocoPhillips is ready to go with an Alaska gas project, she said, but there will be a new Legislature and a new governor, who may “want to start from scratch and set the project back to the beginning.”

Then, she said, there is the gas reserves initiative on the November ballot: “Probably the biggest thing worrying me today is the gas reserves tax.” Kah said ConocoPhillips believes the tax will interfere with and delay the gas pipeline project.

Cyclical oil price issues

Kah talked about factors affecting oil prices and said that she believes oil price is “in a cyclical downturn” but also believes “that we are in a higher-price environment than we were back in the ‘90s when we were used to a $20-a-barrel long-term equilibrium price.”

So why are prices dropping? The U.S. economy is slowing. Demand growth is also slowing, partly as a result of the economy and also because of “price-related demand destruction.”

The high prices have also been due to a change in the financial markets, with more money going into commodities — and now backing out with the slowing economy.

Kah also said she thinks “we are seeing a supply response due to the high prices: there’s just a very, very long time lag,” but some production is starting to come online faster than it would have without the high prices.

“And the fourth cyclical factor I think is an increase in finding and development costs, due to high activity levels.” Revenues are higher, so companies are spending more money “and the service industry just can’t keep pace with us. They can’t add rigs fast enough,” which is forcing up costs.

And then there is staffing: “what we’re all finding is you can’t find the people.” Kah predicted that labor issues will last longer than equipment issues, even though “the equipment issues are severe.”

The China factor

Demand from China is a factor driving demand growth, particularly the high oil demand growth in 2004. But since then China has added coal-fired power, cutting their need for diesel, so “a lot of that demand growth is going away.”

There is also price-related demand destruction, “People have changed their behaviors,” she said. “There’s zero vehicle-mile travel growth last year” in the U.S., some of it due to the hurricanes, “but you could see over time the trend — as prices went up, vehicle miles traveled in the U.S. stopped growing.”

The International Energy Agency is forecasting an increase in production capacity, she said: “supplies are expected to grow at a much faster rate than demand growth.” A huge tranche of production from Organization of Petroleum Exporting Countries, but also non-OPEC, is expected to come online “at a time that the U.S. economy and demand growth is slowing.”

“Inventories are already high and we could see a price collapse next year.”

Kah said “2007 is a particularly problematic year” for prices, with “considerable downside risk.” She also said she expects “prices to continue to cycle down between now and 2010.”

Prices driving costs

Oil prices driving industry costs can be seen in drilling rig day rates in the Gulf of Mexico, she said, with companies competing for rigs and driving up the rig cost.

Then there are steel prices — of great interest to a company planning to build a large gas pipeline, Kah said.

The oil industry doesn’t drive steel prices, “they’re being driven by China,” which is in a phase of industrial development “where they are sucking in every commodity. … And they have actually caused hyperinflation in steel prices; steel prices have doubled since 2002.” Kah said that six months ago it looked like steel prices had peaked, “but they’re rising again now.”

She said it will probably take three or four years “for the world to rebuild sufficient steel capacity … but you know we don’t even have enough ships to move iron ore from Brazil to China,” so capacity needs to be added along the whole supply chain.

With high revenues have come high costs — but also increased taxes. Some increased taxes are related to oil prices and will come down, she said, while others are permanent. The end result is that companies “have much less capital available to invest than we had … five years ago.”

“So I would say this is one of the biggest problems facing our industry today, this hyper-cost inflation, and tax increases. … We don’t have as much money to invest as we did.”

There were two years when prices rose faster than costs, but “unfortunately we’re now in the ugly period where prices have flattened and are coming down, but costs are continuing to rise at a double-digit rate.”

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