Canadian Gas Supply Outlook Gives Cause For Optimism

Jim Oosterbaan
Ziff Energy Inc.
Calgary

Tom Woods
Ziff Energy Inc.
Houston

The Canadian gas industry has more than doubled in size since the mid-1980s.

Gas production has expanded northward in Western Canada and is now poised, with the large discoveries at Fort Liard, Alta., to make a giant leap north of the 60th parallel into the southern regions of the Yukon and Northwest territories.

In addition, gas production off the Atlantic Coast is slated to begin in late 1999.

By all rights, the Canadian gas industry should be successful and looking forward with eager anticipation to further successes and continual growth. But, at this pinnacle of success, an air of concern has developed about Canadian gas supply prospects.

Canadian gas industry growth

Canadian natural gas production has grown to 5.7 tcf in 1998 from 2.7 tcf in 1986 ( Fig. 1 [82,222 bytes]), when deregulation began. This growth has occurred through increases in production from Canada's primary producing region-the Western Canada Sedimentary Basin (WCSB). Concurrently, the Canadian producing sector has reduced its reserve life index (proven), from 21.5 years in 1986 to 8.9 years in 1998-the lowest level ever.

The importance of Canadian natural gas production in the energy mix of the U.S. has also grown. In 1986, Canadian natural gas imports accounted for 5% of U.S. natural gas consumption; by 1998, the percentage had tripled to 14%, while U.S. consumption grew by 5.1 tcf.

This growth in market share has occurred through a combination of price and supply reliability. Ziff Energy expects this growth to continue with the development of North America's newest supply area, Sable Island, as well as through an increase in exports from the WCSB as a result of the construction of additional export pipelines into the U.S.

The WCSB is a rich hydrocarbon-bearing region that is much more concentrated in the occurrence of its hydrocarbons than the U.S. Lower 48 and stretches from Southwest Saskatch- ewan on the east into Alberta, northeastern British Columbia, and the southern Northwest and Yukon territories (Fig. 2 [89,120 bytes]). The WCSB accounts for virtually all of Canadian natural gas production. Natural gas has been discovered in the offshore regions of the Arctic and the East Coast. However, only one region will provide new natural gas production in the next 5 years-the East Coast, which lies close to the large population of the U.S. Northeast. This exciting new supply region will begin production in 1999 with the completion of the Maritimes & Northeast pipeline, expected to be in service in the fall of 2000. Natural gas from Sable Island is ideally situated to compete for natural gas market share in the New England states-the distance to New England from Sable Island is 700 miles, compared with 1,300 miles from the Gulf of Mexico and 2,000 miles from Western Canada.

Industry evolution

In the mid-1980s, the Canadian natural gas producing sector began deregulating. At that time annual natural gas production was 2.9 tcf, and the reserve life index was over 20 years.

This huge excess inventory was a reflection of a regulatory regime that required Canadian producers to demonstrate reserves of at least 25 years prior to being allowed to export natural gas to the U.S. Canadian producers have been reducing this inventory for a decade. The reserve life index had fallen by the end of 1998 to about 9 years, a level similar to the U.S. natural gas producing sector.

During 1986-98, annual Canadian natural gas production grew by 3.0 tcf-of which 0.5 tcf (18%) was due to increased domestic sales; the balance (2.5 tcf, 82%) was a result of an increase in the amount of gas exported to the U.S.

The share of the U.S. natural gas market captured by Canadian production has grown, to 14% in 1998 from 5% in 1986. The growth in exports to the U.S. is largely a function of the city gate price of Canadian gas in U.S. markets, supply reliability, and the availability of pipeline capacity to transport the gas.

Through the 1980s, export pipeline capacity steadily filled to high levels of utilization. In 1992-93, with the completion of the Iroquois pipeline to the U.S. Northeast (0.7 bcfd) and the 0.9 bcfd expansion of the Pacific Gas Transmission pipeline to Northern California, export pipeline capacity grew by 1.6 bcfd, an increase of 25%. This set the stage for increases in U.S. imports and a strong increase in Western Canadian natural gas production.

Concurrent with this growth in market share was a sharp decline of 22% in the value of the Canadian dollar against the U.S. dollar. As Canadian producers sell to U.S. markets in U.S. dollars, this decline has significantly improved the competitive position of Canadian gas. Another factor that enabled Canadian producers to increase their share of the U.S. market over this period was their willingness to make long term (10-15 year) commitments to customers, while most U.S. producers remained wary of long-term commitments.

Annual natural gas production in Western Canada grew by almost 1.2 tcf (25%) during 1992-95. However, after 1995, annual production grew by only 0.38 tcf, as capacity utilization on WCSB export pipelines was virtually at full capacity. Prices for Western Canadian natural gas rose from late 1992 into 1994 (Fig. 3 [85,650 bytes]) with the large increase in production, which reduced excess supply. As a result, gas drilling soared to a new high (5,369 wells) in 1994, just when pipeline development was entering a period of hiatus. Prices plummeted in the latter part of 1994 and in 1995 to as low as $1.14/gigajoule (GJ), or $0.88 (U.S.)/MMBTU.

Beginning in 1995, pipeline constraints in Western Canada resulted in prices "disconnecting" from prices in the U.S. During this price disconnection, the basis differential soared from $0.34 (U.S.)/MMBTU to $1.20 (U.S.)/ MMBTU in 1997, prompting the 1998 expansion of the Northern Border pipeline and the launch of the Alliance pipeline project.

Alliance is planned as a greenfield, high-pressure, high-liquids-volume pipeline with capacity of 1.3 bcfd. The pipeline will extend 1,900 miles from Western Canada to Chicago and is expected to cost $3.4 billion (U.S.). The project involves five of the largest North American pipeline megacompanies-Westcoast Energy Ltd., Enbridge Pipeline Inc., Coastal Corp., Duke Energy, and Williams.

Despite the price environment, Western Canadian producers have continued to connect a significant number of gas wells (Fig. 3). During 1996-98, an average of 4,400 wells were connected annually despite the prices being paid for Western Canadian gas supply. Prices rose strongly from mid-1998 on, as parties began to express concerns about the capability of producers to deliver additional supply expected to be required as a result of the expansion of the Northern Border pipeline, which started up in December 1998, and the start-up of the Portland Natural Gas Transmission System (Pngts) in March 1999 and Alliance in November 2000.

Pngts is a greenfield pipeline that extends from Pittsburgh, N.H, to Portland, Me. Pngts will have a capacity of 178 MMcfd, and it began service in the first quarter of 1999.

Near-term outlook

There are three significant developments that will affect Western Canadian production and prospects through 1999-2001.

The first is a significant expansion in ex-basin pipeline capacity. Pipeline capacity will have increased by more than 2.6 bcfd (30%) in just 2 years, from the fourth quarter of 1998 to the fourth quarter of 2000. Those pipeline expansions are directed to serving expanding markets in the Midwest, Mid-Atlantic, and Northeast regions of the U.S.

Another significant event is the proposal by TransCanada Pipe Lines Ltd.-Nova to revamp its tolling methodology from a postage stamp approach to one that reflects the distance of haul and the facilities used. If approved as proposed, this approach will result in higher intra-basin transportation tolls for producers that are located at the northern extremities of the Nova transportation system.

The third development is the growing concern about environmental issues in Western Canada, which range from gas processing air emissions to land access.

This year will mark another milestone in the Canadian natural gas industry with the beginning of production from the Sable Island region that will transport gas to new markets in the Canadian Maritimes and the U.S. Northeast. This region is at the earliest stages of its development and has considerable potential to increase production from existing and new fields, as it is well-situated to compete for markets in the U.S. Northeast. Initially, production from Sable Island is unlikely to affect the volume of gas sold in the U.S. by Western Canadian producers.

Canadian gas issues

These issues pertain to Western Canadian gas production, given the dominance of the WCSB with regard to Canadian production and the newness of Sable Island production.

WCSB gas deliverability

There is a significant concern on the part of many industry participants about the ability of Western Canadian producers to provide the level of deliverability that is expected as a result of the expansion of ex-basin pipeline capacity.

This concern is driven by a number of factors: rising decline rates for new wells; a perceived decline in the productive capability of new wells; concerns about the capacity of the drilling sector or the availability of capital to drill the number of wells that are expected to be required; and a reduction in the gas inventory.

These concerns have combined to considerably strengthen cash and forward prices in Western Canada, but have also increased concerns on the part of downstream markets about the long term reliability of Western Canadian supply.

Gas demand

More than 90% of the new ex-basin pipeline capacity is directed to export markets in the U.S. Following steady growth through 1995, U.S. gas consumption showed little growth in 1996 and 1997 and declined by more than 600 bcf in 1998. While a major share of this decline reflects warmer than normal winter weather, U.S. industrial gas consumption has also begun to decline, and this decline is not weather-related.

Most analysts project that the growth in demand will arise primarily as a result of growth in gas-fired electrical power generation. This expectation is built principally on an expected decline in nuclear generation and limited growth in coal-fired generation of electricity. However, nuclear generation of electricity in the U.S. just missed setting a new record in 1998. Coal-fired generation continues to grow.

To state the obvious, natural gas competes with other fuels for a share of the existing industrial market. This market segment has subsegments with different levels of demand elasticity. Current forward prices for Western Canadian supply are near $3.00/GJ or $2.15/MMBTU at the Empress, Alta., market point. These price levels will place pressure on existing sales of Western Canadian natural gas as well as sales into new markets.

Western Canadian producers sell into the U.S. market at U.S.-denominated prices. This practice is advantageous when the value of the Canadian dollar is low or falling, i.e., a U.S. dollar is worth more Canadian dollars, as during the 1990s. Currently, the Canadian dollar/U.S. dollar exchange rate is near its lowest level ever. If the value of the Canadian dollar relative to the U.S. dollar should strengthen, this would squeeze the profitability of Western Canadian producers.

Downstream transportation

More than 2 bcfd of expansion pipeline capacity is directed to the U.S. Midwest market ( Fig. 4 [90,158 bytes]).

On an average-day basis, the Midwest is currently overpiped.

To avoid a glut of Canadian gas at Chicago, more pipeline capacity to move the gas downstream from Chicago to other markets needs to be constructed. Projects to move that gas to other markets have been announced.

The market share of Canadian gas will increase by pushing out some U.S. gas from this region. However, any delays in the in-service dates of that capacity will result in Western Canadian gas pooling at Chicago. This would likely result in downward pressure on both New York Mercantile Exchange (Nymex) and Western Canadian prices.

Cash flow, price disconnect

Not many oil and gas producers in Western Canada are weighted more than 50% to gas production.

With the downturn in oil prices in 1998 and early 1999, it was widely expected that the reduction in industry cash flow would affect both oil and gas-directed exploration and exploitation activity. However, gas directed-drilling has continued at strong levels through April 1999.

On another issue, the construction of additional export pipeline capacity has resulted in Western Canadian gas prices reconnecting to prices in the U.S. The basis differential between Empress and Nymex had declined to $0.18 (U.S.)/MMBTU by April 1999, less than the effective cost of transportation ($0.60 (U.S.)/MMBTU.

The reconnection of prices means that factors affecting Nymex prices begin to affect prices in the WCSB. In an environment where pipeline capacity is available to U.S., it is likely that U.S. prices will provide support levels for Western Canadian prices.

Conclusions

Canadian gas producers have entered a period where prices will allow for the recovery of full-cycle costs (the cost to develop, operate, and earn a return on gas production).

Since 1985, when deregulation began, prices have rarely allowed producers to recover full cycle costs. The major driver of Western Canadian gas prices over the next 18 months will be what we refer to as the "Great Alberta Gas Mystery": Does the WCSB have sufficient deliverability to meet the demand that is generally expected to arise as all the additional pipe capacity goes into service?

This concern about deliverability could generate a dilemma for Western Canadian producers-where the level of prices will affect market demand for natural gas while concurrently fostering a strong level of drilling and connection activity that will increase deliverability.

Current cash and forward prices can be expected to attract capital into the industry that will support a significant level of drilling activity. For example, for the first 4 months of 1999, there were more than 2,000 gas well completions in Western Canada, the highest level of activity ever for a 4-month period.

The concern about deliverability for Western Canadian gas supply is also driven by a belief that the quality of the gas resource in Western Canada has diminished. There are much data that can be assessed on this issue. Not all the data will lead to a similar conclusion.

The share of the U.S. natural gas market held by Canadian production can be expected to steadily increase well into the next decade. Canadian producers can be expected to continue to aggressively compete for market share.

Given the immaturity of the WCSB vis-à-vis its U.S. counterparts in the Lower 48, the WCSB will continue to be a major source of incremental gas production.

And on the eastern edge of the continent, the Sable Island gas play is well positioned to compete for market share in the underserved East Coast region that lies at the end of the large, constrained pipelines from the Gulf of Mexico.

The Authors