June 29, 2016

Western Canadian natural gas producers could be facing lowerprices this summer unless production is shut in or they find ways to move itout of the region as storage levels are unusually high for this early in theinjection season, say analysts.

“There are a whole bunch of moving parts there, but right now in WesternCanada we are running way too close to the edge in terms of full storage,” GilDawson, co-founder and managing partner with Turnstone Strategy, aCalgary consultancy, said in an interview.

According to Canadian Enerdata, storage in the west is around90 per cent full as of June 17, up from around 63 per cent the previous year.

“If clearly we are going to fill storage in the next few weeks,the price moves will be more dramatic, trying to drive more shut-in behavioursand more exports,” said Dawson. “The price will be a function of how dire theproblem is.”

“This is a physical price movement, not a market betting on somecoming future issue,” Dawson emphasized. “The physical market will run theshow; if we are not going to hit full storage, those prices can move up. If weare at serious risk, short term, of hitting full storage, then prices willprobably have to move down hard until the problem has been solved.”

Although companies that are able to hang on through the summershould be looking at considerably stronger prices post-injection season, first“you have to get to next winter,” he said.

The high level of gas in storage in Alberta is “very unusual” forthis time of year, said Richard Frey, an analyst with Colorado-based Platts/Bentek.

“You’d expect to see that in the fall, not near the beginning ofthe injection season,” agreed Ed Kallio, an independent energyconsultant. “Given that we had a very mild winter, we were seeing storage fillson winter days and that’s why we went into the injection season with a veryhigh level of storage and that has continued obviously.”

The industry has two choices when it comes to dealing with thecurrent gas glut, according to Dawson. “You move more gas out or you are forcedto constrain supply until storage is no longer a problem,” he said. “Prices aretrying to evolve but I would argue they have not yet achieved any of thatobjective, so clearly at the present inventory injection we still have troubleahead for us.”

Turnstone expects to see more price weakness in Western Canada andthe wide differential between western Canadian and United States markets remainin place until ultimately the lack of Alberta storage capacity is resolved,said Dawson. “The bottom line is that if you have full storage, you shut inanyway.”

“What we have seen is low gas prices in Western Canada trying tosuppress supply,” he said. “The differential between AECO and U.S. gas pricesis very high right now so we are trying to drive gas into the U.S., and withthe wide differential, Western Canadian Basin gas is pretty attractive.”

Temperatures in the U.S. Midwest this summer are expected to behigher than normal and there has been a high power demand for the last coupleof weeks, Frey noted.

LNG pre-drilling, mildwinter cited in high storage levels

Several factors have contributed to the current high storagelevels in Alberta. In addition to an exceptionally mild winter in which thereactually were storage fills on some days, there was the one-time event ofdrilling to prove up enough reserves for final investment decisions on LNGprojects, according to Kallio.

Alberta storage was 75.2 per cent full at the end of March 2016heading into the injection season compared to 42.5 per cent full a yearearlier. “It’s like starting a 100-yard race at the 80-yard line,” said Dawson.

Adding to the storage glut was the loss of about one Bcf per dayof oil sands demand in May due to the wildfires in the Fort McMurray area,although that demand is gradually picking up.

More low prices, shut-ins

There have been some days where gas has been selling for C50 centsa gigajoule at AECO and “I was hearing even a dime,” said Kallio, who suggestedthere could be more 10 cent days this summer. During the weekends, when demandis low, producers may even pay to have someone to take it away with someunutilized pipeline capacity, he said. “But if you don’t find it, you shut itin.”

Producers will look at shutting in gas when the price gets belowtheir operating costs plus the royalty, according to Kallio. “We have seen italready and a lot more gas will be shut in,” Kallio predicted. For producers,shutting in gas is usually considered a last resort because there is the riskof the loss of some productive capability from the wells, he said. “When yourestart, sometimes you don’t make up that lost production, although sometimesyou do; sometimes the pressure is higher,” according to Kallio. “It’s somethingyou don’t know until you do it so they are very hesitant to do it.”

Export markets

Both Frey and Dulles Wang, principal analyst in Calgary forWood Mackenzie, question whether additional gas will be shut in. “Ifcompanies didn’t cut their production when prices were US$1.50 per MMBtu, theyare not going to cut it at $2.50,” said Wang. “In our view, whatever has beenshut in is still shut in but nobody is shutting in more.”

As prices have gone up, producers are trying to push as much asthey can to the TransCanada [Corporation] Mainline, which is themarginal pipeline, he said.

“If you are looking at the past few weeks as an indication of whatis to come, you are going to see more and more interruptible flows on theTransCanada Mainline, dropping off gas at Emerson [Manitoba] or off the GreatLakes pipeline to help debottleneck the region.”

While the Northern Border pipeline goes into the UnitedStates Midwest, “you are trying to displace Bakken gas but it’s pretty muchfree and it’s closer to markets,” Wang noted.

In order to flow gas on a short term firm or interruptible basison the Mainline and from there into the Midwest where there is strong demand,producers need a wide differential between AECO and Henry Hub (over US$1 per MMBtuin Wood Mackenzie’s view). “It covers the transport cost to Emerson and that issomething you are seeing already,” he said.

TransCanada, though, has not yet seen any increase ininterruptible flows to Emerson, according to Terry Cunha, a companyspokesperson.

Stronger winter pricesforecast

Post injection season, Turnstone is bullish on prices as gas ispulled out of storage. “We think there is going to be a real shortage of gasinjected to deal with next winter,” said Dawson. “We think that supply will beextremely weak in North America and gas storage in the U.S. also probably willbe weak, at or below average by next winter.”

The company believes that for now the Greater Marcellus (Marcellusand Utica) in the eastern U.S. has been sidelined for lack of takeaway capacityout of the region. That also is the only place where there are drilled butuncompleted gas wells that could quickly be brought on production, he said.“Until you get a lot more capacity out of the Greater Marcellus, it is juststuck in the penalty box.”

In addition, any additional compression on the REX [RockiesExpress] pipeline transporting Greater Marcellus gas westward won’t come onuntil the second half of 2017, according to Dawson.

Peyto Exploration and Development Corp., which has deferredbringing on significant new production until the fall when it will have lockedin higher prices through hedges, is already beginning to see a higher forwardcurve, said Darren Gee, company president and chief executive officer.

Ontario customers currently are reluctant to buy Alberta gas atAECO to fill their storage because they don’t want to pay the high interruptibletransportation rates on TransCanada but in the process are exposing themselvesto gas shortages this winter, he suggested.

“It’s sort of a game of chicken,” said Gee. “They did the samething in 2013 and all of a sudden in the fall when winter was coming and theyneeded the gas, they capitulated and the expectation is that they are going todo exactly the same.”

Turnstone Strategy Inc.
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