Geographical differences in energy prices

by: Hans van Cleef

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  • US natural gas appreciation came to a halt after a 34% rally
  • Oil prices are under pressure on hopes of increased output
  • OPEC output dropped to 2.5-year low, but bigger challenges emerge

 US natural gas rally curbed

Since the start of November 2013, US natural gas prices (Henry Hub contract) have rallied substantially. In our Quarterly Outlook (released on 31 October last year), we stated that US natural gas prices would rise from the spot price of USD 3.58/mmBtu to USD 4/mmBtu before the end of the year. The expected rally indeed materialized and even stronger than anticipated. In fact, the first contract touched a high of USD 4.53/mmBtu, before it ran into a brick wall. The reason for the impressive appreciation was a period of frigid cold in a large part of the US boosting heating demand. With US stockpiles dropping significantly over the past few weeks, the Henry Hub prices rallied by more than 34% since the low of USD 3.38/mmBtu on 5 November. On 31 December, however, the natural gas price dropped more than 20 cents, or more than 4.5%, due to year-end profit taking. In Europe, weather conditions were mild, preventing a similar rally. Even if the recent Henry Hub rally narrowed the price difference somewhat, geographic differences will keep European natural gas prices higher than US gas prices.. Nevertheless, the price rally in the US can be considered positive from the perspective of competition between the US and European gas industry.

The question is whether the US gas price rally will continue, or whether we will see more profit taking. The answer is not as easy as it may seem. First of all, it is always hard to tell during the first half of January whether thin liquidity results in exaggerated moves. Such moves will usually mostly be corrected during the second half of the month. Secondly, the heating season is still running and the US economy continues to expand at a strong rate. It is not clear yet, whether the ongoing growth is already priced in. Normally, strong economic growth should lead to a continuation of the price rally. However, at least three factors will probably prevent US natural gas prices from rising much further in the near term. The first factor is that higher prices will re-activate production capacity that had become too expensive when gas prices were lower. Higher output will balance the rise in demand and keep inventories up, thus capping the upside of natural gas prices. The second factor is that demand may soften as a result of the higher prices. A third factor is that seasonal demand will ease and, subsequently, inventories will build up in the course of this year’s first quarter. As a result, we expect US natural gas prices to ease somewhat after heating demand fades away, but to stay firm on the back of economic growth. All in all, our expectations are for an average price of USD 4.25/mmBtu in 2014.

 2014 started with significant pressure on oil prices

Oil prices showed a similar pattern as natural gas prices – including the geographical differences –in the last six weeks of 2013 (figure 2). As a result of the cold weather in the US, as well as the declining inventories and strong industrial demand, WTI found strong support and even touched levels above USD 100/bbl at the end of December. Brent oil, on the other hand, appreciated due to supply disruptions in South Sudan and the ongoing worries about decreasing output in other regions. In January, however, WTI dropped by 5% and Brent by 4% on rumours that Libya would soon restart production at a key oil field. As with natural gas prices, it is still too early to tell whether this will be the direction in the coming months. With demand expected to pick up in the course of the year, mainly in the US and Asia, some price support can be expected. However, there is also large potential for production increases, which should be more than enough to balance the higher demand. In fact, if non-OPEC production (mainly in the US and Canada) continues its upward trend, production disruptions in Iraq, Libya, South Sudan and Nigeria ease and the sanctions on Iran are (partly) lifted, an extra several (> 3 mb/d) million barrels of oil per day could be produced . The main question is whether this additional supply will indeed hit the market, or whether the existing tensions will keep the pressure on oil markets in 2014. If the tensions in the Middle East continue – especially combined with a rise in demand – oil prices could remain volatile, but sideways moving, similar to the pattern we have seen in the previous three years. Again, it is too soon to tell, but we will come back on this in updates at the end of January and early February. For the moment, we keep our oil price forecasts unchanged (see table 1).

 

OPEC output under pressure amidst other challenges

During the last months of 2013, OPEC production was under pressure, mainly because of steep declines in production in Libya and Iraq (figure 3). In fact, OPEC output dropped to a two-year low because of these disruptions. Especially the heavy decline in Libya – with almost 1.4 mb/d accounting for more than half of the total OPEC supply disruptions – had a big impact on market sentiment. Figure 3 also shows that Saudi Arabia always increases its production if needed. So, even despite production disruptions in the most important oil-producing region, there is still ample supply. This is one of the reasons that oil prices did not balloon, in combination with increased output in non-OPEC regions. On the other hand, tensions in oil-producing countries – or in countries that are in the vicinity of major oil producing countries and therefore pose the risk of a spill-over – kept risk premiums high and prevent Brent prices from dropping significantly below USD 100/bbl. Hopes are building that additional production will come back to the market in the course of 2014. Negotiations with Iran look promising and may eventually result in an easing of the sanctions. Also the possibility of a return of Iraqi and Libyan oil paves the way for lower oil prices this year, even if Saudi Arabia would cut back its production. After all, a cut in Saudi output increases its reserve capacity, which may be called upon again in case of (renewed) escalation of tensions or new production disruptions. Overall, there currently is no reason to expect significant oil price rallies based on production disruptions in the Middle East.

Nevertheless, there are some potential challenges building for OPEC in the somewhat longer term (3-5 year). In December, OPEC voted to keep Libyan El-Badri as President of the Conference of OPEC and Mrs. Alison-Madueke as the Alternate President– both for one year –, which solved one of the problems for now. The remaining challenges are: 1) the return of Iran oil if sanctions are indeed eased; 2) the ambition of Iraq to triple its oil output; 3) the need of Saudi Arabia to finance its fiscal/current account; 4) how to deal with the US shale oil boom; 5) the shift in the oil consumption market (from the US to Asia); 6) the US becoming less dependent on Middle East oil); 7) rising production costs throughout the region; and 8) delayed investments in the face of surging US shale output. These challenges must be dealt with in the coming years to prevent a supply crunch – and consequently an impressive price increase. There is still time, but the coming OPEC meetings will be very interesting to watch. Any disagreement on the topics mentioned above becoming public could lead to additional price volatility.