Despite all the bluster surrounding their meetings, OPEC’s ability to control world oil prices has always ranged between ineffective and ephemeral. The cartel’s announced cut of 1.5 MMB/d last Friday was no exception to the rule. In today’s context of seized up supply chains and falling demand, OPEC’s efforts are akin to plugging a leaky oil barrel with a piece of cotton.

For now, we need to look elsewhere for optimism among the energy commodities. Natural gas, always the quiet cousin to oil, looks far more promising with greater potential for price to rebound earlier. Unfortunately, for now we’re still plagued with the financial crisis. Capital markets in nations around the world are still woefully short of money, the primary lubricant required to rev an economy normally.

That means the gears of commerce will be grinding for a while yet, screeching painfully louder until capital starts flowing again. Without access to normal banking credit, many supply chains are not functioning in their usual manner. Commodity cargoes and inventories, including for oil, are often financed with credit. No credit, no delivery. That means many of the indicators measuring oil fundamentals, for example petroleum demand or imports, are neither reliable nor representative of normal conditions right now.

One set of indicators that are undeniable relate to natural gas. If there is any sense of optimism for Canadian natural gas producers, it’s that North American natural gas is going to tighten over the next 12 months, possibly as soon as this winter. Excitement by producers isn’t warranted yet, and I’m not saying that we’re going to see $12 gas anytime soon, but fundamental support and an upward price bias could return earlier than most think. The key driver is the credit crisis and weak prices, both of which are clamping spending. Lack of capital invested back into exploration and development will diminish the rate of production. Early quantitative and qualitative indicators are starting to show this.

In the past couple of weeks there have been very material budget cuts announced by North American natural gas producers. For example, last week five of the larger publicly-traded US companies that are active in shale gas plays announced budget cuts of $5 billion in 2009. Countless, smaller private companies are anecdotally known to be shelving drilling plans too. The US rig count is already falling and Nabors Drilling, the largest drilling contractor in the world, announced last week that the US rig count could drop by a staggering 300 rigs, or about 15% over the next year.

Compared to oil, the productivity of natural gas reservoirs decline far faster – four times faster than oil – if not drilled. If rigs don’t continually punch holes in the ground, production starts to fall off quickly, like a just-in-time delivery system. As a result, the amazing supply surge from shale gas plays, like the prolific Texas Barnett Shale, is assuredly going to slow. From a continental perspective, natural gas production has a high probability of flattening out and even posting a year-over-year decline.

It’s too early to call numbers, but by the New Year the magnitude of the trend will be evident. In Alberta we are not immune to foreclosures in Cleveland and bank failures in Reykjavik. Furrowed foreheads in boardrooms across Calgary are cutting drilling budgets too. Yes, it’s true that some of the chips are being reallocated to BC and Saskatchewan, but the reality is that 80% of gas supply comes from Alberta.

The royalty collectors out of Edmonton have a bigger tin cup starting this January, and industry captains are speaking with their checkbooks – smaller checkbooks at that. Alberta’s natural gas production is now down about 1.7 Bcf/d, or 12.5%, since the high recorded in the summer of 2006. We can expect the loss of another 5% in volumes over the next year as drilling in Canada weakens further too.

Demand for natural gas in North America is not growing, but not falling either. Unlike oil, the demand for gas is generally insensitive to changes in economic growth (or lack thereof). Only industrial demand is likely to be soft. The weather forecast for this winter looks to be cooler than the 5-year average, which means that storage levels are not likely to peak. Strong weather demand paired against weakening production could turn a year-long supply surplus into a mild deficit quickly.

Our current view is that North American gas prices at Henry Hub will average $US 7.50/MMBtu next year, but if production growth starts declining as expected, prices could be higher. Certainly the early, leading indicators are pointing in the direction of tighter fundamentals. And that strength is reinforced here for Canadian gas exporters; our dollar had declined 17%, or 16 cents, over the past month.

Each penny drop translates into a $C 0.09/GJ rise in domestic price! It’s still early for Canadian natural gas producers to get excited, but at least the indicators are starting to point to a more optimistic set of circumstances amidst the sound of grinding gears.

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Peter Tertzakian, Chief Energy Economist

Kara Baynton, Manager, Energy Research

Disclaimer The information and data contained herein has been obtained or prepared from sources which ARC believes to be reliable but has not been independently verified. ARC makes no representations or warranties as to the accuracy or completeness of such information and data nor the conclusions derived therefrom. This document has been published on the basis that ARC shall not be responsible for, and ARC hereby expressly disclaims any responsibility for, any financial or other losses or damages of any nature whatsoever arising from or otherwise relating to any use of this document.