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How the ‘Big Reset’ changed the odds on gas prices

At the end of March, not even a seasoned gambler would have put odds on the "Big Reset." For sure, nobody in Canada's oil patch would have wagered two bucks (or a thousand cubic feet of natural gas) on the unlikeliest of outcomes: That the largest ever surplus of gas accumulated in U.S. storage caverns would burn off before winter.

It's too late to get the high odds now. U.S. natural gas inventories look like they will be at or close to normal – the benchmark five-year average – around the time the first serious snowflakes start to fly. So, chances are good that long-depressed North American prices will rally over the winter. Now, the riskier bet is whether you believe that higher prices will sustain into 2013.

Currently we're in the fall shoulder season, the time of year when both air conditioners and furnaces are resting their bearings. In five or six weeks, when the fleece come out of the closet, the price of natural gas at the benchmark Henry Hub should escalate to approximately the $US 3.25/MMBtu range ($C 2.75/mcf AECO), assuming Jack Frost sticks to his usual schedule of cold blasts. Above $US 4.00/MMBtu holds some promise if, unlike last year, old man winter gives us an impressive performance in December and January – the coldest months of winter.

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Year-to-date 2012, the price of natural gas has averaged $US 2.53 /MMBtu ($C 2.15/mcf at AECO). That depressed level of price, which offers no return to most producers, has mostly been a consequence of expanding storage levels, which began ballooning out a year ago September (see attached chart). An unusually warm winter dampened heating demand and conspired with elevated levels of production to create the biggest surplus ever.

At its peak in March, 927 billion cubic feet of surplus of natural gas was pressurizing U.S. storage caverns – a bloat big enough to supply the entire continent through a 10-day cold snap. Back then, a Big Reset down to the zero line in time for winter meant that an incremental 4.1 Bcf of daily consumption (about 7 per cent above normal demand) would have had to materialize.

It did. With its low price, natural gas has proved to be more fiercely competitive against coal than anticipated. New demand from the power generation market began mopping up the surplus gas when Henry Hub prices dipped under $2.50/MMBtu early this year.

The outlook for price appreciation remains positive over the high-demand winter period. Thermostats will get turned up in two to three weeks. Power utilities should continue calling for above average volumes in the interim, further burning off the surplus. Drilling rigs are continuing their migration toward oil, so natural gas production should remain flat at best. In fact, in less than a month the charts will record one full-year of no-growth, flat production; that's a further catalyst for stronger prices after three years of relentless, year-over-year aggressive capacity expansion.

Jaded by the shale-gas assault, there are many producers who won't believe that higher prices are sustainable, even though the futures curve indicates such a trend. That lack of conviction is likely to create deflationary behavior – actions that accompany the belief that tomorrow's gas prices are likely to be less than today's. With this kind of psychology, producers will rush to sell as much product as they can to capture any price rally. In the case of troubled companies with tattered balance sheets, there is double the incentive to sell as much natural gas as possible into a rising market.

Rushing to complete wells and tying them into pipelines before an expected price fall is a self-reinforcing behaviour that could create a momentary supply boost again in the latter half of winter. Validating this conjecture is data from 2010, the last time there was a meaningful price rally. It showed a noticeable uptick in output volumes from existing North American gas wells.

The Big Reset favours a price rally this winter. How much of a rally, or lack thereof, will depend on the severity of the cold. So the near-term bet for where natural gas prices are headed is now largely a function of weather. Heading into spring 2013, the bet will be on producer behaviour. Hopefully, they won't bet against themselves.

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