Hurtling Headlong Into A Supply Crunch

In 2005, opportunities in the Canadian natural gas sector had never looked better...

Gas prices were soaring across North America – thanks to strong demand for clean electricity and accelerating production in the Canadian tar sands.

Then Hurricane Katrina propelled gas prices to more than $15/mcf.

Money rushed into the western Canadian gas sector. In 2005, the number of drill rigs in the region increased by 25%. But in 2006, the market reversed. No hurricanes struck, the winter was warm, production was plentiful, and storage inventories in the U.S. turned into large surpluses. The price of gas collapsed more than 60% and deterred explorers from looking for natural gas.

To make the situation even worse, labor, equipment, and power costs soared in western Canada. And then, on Halloween, the Canadian finance minister announced the end of the special tax exemption for income trusts – a popular structure among natural gas explorers.

The reaction was swift. According to the Petroleum Services Association of Canada, the rig count in western Canada has dropped about 50% from a year ago, and total drilling activity for 2007 will be about 18% lower than 2006.

Not only have rig counts declined, but production per rig is declining as existing deposits deplete. According to the Ziff Energy Group, the average production of a Canadian gas well is down 41% since 2000.

Meanwhile, demand for natural gas looks healthy in Canada. Not many people realize this, but it takes huge quantities of natural gas to produce oil from the tar sands.

Steam is used to separate the oil from the sand after the workers have dug it up from the ground. Well, to make that steam, you need natural gas... a thousand cubic feet of natural gas for every barrel of oil processed.

The Canadian tar-sand industry currently consumes about 1.1 billion cubic feet of natural gas every day. Of all the gas consumed in Canada every day, more than half of it is used to turn bitumen into oil in the tar sands region.

In my previous column, I talked about oil companies' plans to quadruple their production in the tar sands over the next 18 years. Well, that means demand for natural gas will multiply too... probably to around 3 billion cubic feet per day by 2025.

It looks like the Canadian government is becoming environmentally friendly as well. Unlike the U.S., Canada signed the Kyoto agreement and is trying hard to curb greenhouse gases. Here's one example: Politicians in Ontario are trying to close down all five of the province's coal-fired power plants and replace them with natural gas plants by 2010.

Think about this for a second. On one hand, demand for natural gas – for making electricity and separating oil from sand – is set to explode. On the other hand, the number of rigs looking for oil in Canada has fallen in half.

It looks to me like we're charging headlong into a supply crunch in the Canadian natural gas market.

Seeing as Canada provides 16% of the U.S. natural gas demand and the U.S. supply position is just as precarious – I am very bullish on the price of natural gas. In fact, the market is already showing signs of perking up, rising from $4 to $7 in the last six months.

In sum, I think there's a good chance natural gas may rise above $10/mcf in the next 24 months. Although you can investigate the new natural gas ETF, I think you'll get more bang for your buck with the plays we discussed on Monday.