Gulf between oil, gas prices the greatest in 10 years

Good news for oilpatch, bad news for producers

Claudia Cattaneo,
Financial Post
July 25, 2006

CALGARY - Natural gas prices are so depressed relative to crude prices that the divergence between the two has widened to a decade-high, Ziff Energy Group said in a report yesterday.

The price of one thousand cubic feet of natural gas -- at about US$6 -- has slumped since last fall to 1/13th of a barrel of oil, down from an average 1/7th last year and a far cry from the gas-to-oil conversion rate of six-to-one based on heat equivalency. Crude rose above US$75 a barrel yesterday.

Paul Ziff, president of the energy advisory firm, said such a huge gulf is rare and last occurred in October, 1996.

(At the time, oil jumped to US$24, up US$2, on big demand in Europe and a hurricane in the Caribbean, while gas dropped due to mild weather to US$1.86 per mcf).

"It will be self-correcting," Mr. Ziff said in an interview of the latest gap. "It will be painful in the interim, and certainly oil is the place to be in the short term. It also shows that unless a company is hedging to protect margins, there is a virtue in having an oil and gas balance in one's operating portfolio."

Oil prices are unusually high because widespread geopolitical unrest is adding a large risk premium.

Gas prices are depressed because there is too much gas in storage following a warm North American winter that could result in inventories being filled for the coming winter heating season a month or two ahead of schedule.

In addition, gas prices are under pressure because production knocked out by hurricanes in the U.S. Gulf of Mexico last year has been restored while industrial demand has been damaged by last year's price spike to $14 per mcf.

Mr. Ziff said the ratio is likely to remain wide at least until the fall.

Meanwhile, the decoupling is creating winners and losers.

The winners are gas consumers and oil producers, and particularly oilsands and heavy oil operators that use gas to produce oil. Oil producers are expected to report record profits this year.

Gas producers, faced with a cost of producing new natural gas of more than US$6 per mcf, are being squeezed. Some natural gas producers have started to cut back spending to match reduced cash flows and are examining natural gas production "trim back" strategies, while some gas-leveraged income trusts have reduced their distributions.

"Further pressure on gas producers and explorers comes from service supplier costs, which have been rising at 20% per year due to high energy commodity prices," the advisory firm said.

"However, many of the suppliers of services do not distinguish between oil and gas, so the cost burden for gas producers will be disproportionate -- gas operating margins are becoming compressed, and returns from new gas drilling are also being squeezed hard, from the high returns in the past several years, to single digits, or less. Investors are apt to be surprised by the extent of the reversal."

Mr. Ziff predicted that second-quarter financial results for gas producers will be flat to down, and "will not be attractive" for the past two quarters of 2006.