As of 29 September, Alberta Energy Co (AECO) spot prices closed at -CDN$0.55 per GJ, down $2.25 from August's closing price of CDN$1.70. Futures also went sharply lower. October (the front month) AECO futures are currently trading at CDN$0.90 per GJ. AECO natural gas futures are an important commodity indicator for upstream operations in Alberta's and British Columbia's Western Canadian Sedimentary Basin (WCSB), which hosts numerous plays including Bakken, Cardium, Montney, and Duvernay.
Figure 1: Oil and Gas Plays of the Western Canadian Sedimentary Basin
Source: PacWest/IHS via PointLogic (an IHS-Markit Company). "Canadian Natural Gas: Stuck Between A Rock And A Hard Place," June 5, 2015.
Over the short term, negative prices are an acute market price signal to shutter and/or strand excess capacity. On a longer time frame, they signal the need for improved logistical infrastructure.
Superficially, negative pricing is driven by logistical bottlenecks. The region's limited take-away capacity is historically prone to interruptions. The AECO futures market expects that negative pricing will be short-lived.
However, the root causes of the imbalance may be more persistent than the market currently expects. The confluences of prolific new wells coming online, rapid efficiency gains, frequent pipeline outages, and seasonal maintenance has resulted in a supply imbalance that has in the past proved to be resilient to price signals.
Many producers who are forced to shutter existing and future production will experience a deleterious combination of both lower (foregone) revenues and higher costs. On the other hand, this development could be interpreted as a strong counter-cyclical and contrarian indicator.
Negative Prices Signal Acute Imbalance
Over the last few days, AECO gas prices went into negative territory, signaling an acute imbalance between supply and logistical capacity. As 29 September, AECO spot gas prices settled at -CDN$0.55 /GJ while October futures have settled down to CDN$0.90 / GJ. Outages of Canada's gas pipelines happen every summer due to heightened operations as well as planned maintenance. Still, negative commodity prices are extraordinary; negative AECO/NOVA prices have not been reported in at least 15 years.
Figure 2: AECO Gas Spot and Futures Prices - Daily Close
Source: Oil Sands Magazine. "Energy Statistics: Oil and Gas Prices."
Additionally, regional gas prices elsewhere are not experiencing nearly this level of distress, signaling that present extreme prices are probably temporary. Canadian crude oil and natural gas supply has historically exceeded demand. Prior to the 2009, the regional imbalance was counterbalanced by high demand from the Lower 48 States (L48), resulting in both narrower differentials and higher prices. Since then, North American gas prices have plummeted. Furthermore, the basis between AECO and Henry Hub (the primary natural gas benchmark for the L48) has been widening since 2015, stemming from increasing cost competitiveness of gas production from within the L48. In any case, Henry Hub Futures are relatively more stable near the $3/MMBtu handle, indicating that the bottlenecks are localized and that sagging Canadian prices are not the result of sagging global demand.
Figure 3: Global Natural Gas Spot Prices (Monthly): January 2000 - Present
Source: Canadian Gas Association - Gas Stats. Natural Gas Prices, monthly (Global).
Furthermore, the futures market is also signaling that the logistical problems are short-term. The steeply upward sloping futures term structure of deferred futures contracts are trading closer to historical norms. This indicates that the market expects that shut-ins will rationalize the logistical bottlenecks within the very near future.
Figure 4: AECO C Future Pricing
Source: Gas Alberta Inc. Market Prices.
Also of note, Alberta's and British Columbia's combined marketable natural gas production was much higher over the previous decade. This further supports the narrative that constraints are localized and temporary.
Figure 4: Alberta Marketable Natural Gas Production (mcf/d): January 2000 - June 2017
Source: Government of Canada. National Energy Bureau. Marketable Natural Gas Production in Canada.
Thus, on the whole, the bottlenecks appear to be temporary and that given time, this market will rationalize itself by either scrapping excess production and/or incenting expansions to midstream infrastructure. One source recently reported that "high demand for the line caused Alliance to ask gas producers to commit 500 million cf/d more gas to an expansion project on the line."
Possibility of a Protracted Ultra-Low Price Environment
Yet it is also possible that extreme prices may be symptomatic of conditions which may lead to a lower-er for longer-er pricing scenario for AECO. The WCSB is host to numerous tight pay zones, including the Bakken, Cardium, Montney, and Duvernay. Production in these areas has been ramping up, while production from legacy conventional reservoirs has been steadily declining. Thus, logistical bottlenecks are merely symptoms of rapidly increasing production in areas which are dislocated from legacy gathering and transmission assets.
Even though pipeline outages are common during the summer season, outages servicing the WCSB have been abnormally common this year. Outages have been documented in February, June, and August of 2017. NGI broke with the most recent spate of interruptions just last Tuesday. Whereas market forces dictate the pace of development in Alberta's highly fractured upstream industry, the region's logistics industries are highly consolidated among fewer companies playing the role of toll collector. In an August research missive, Raymond James analyst likened Canadian pipeline companies to an oligopoly, in which scarce competition has led to poor service.
Figure 5a: Canadian Natural Gas Pipelines
Source: Canadian Energy Pipeline Association (CEPA) via Government of Alberta. North American Natural Gas Pipelines (as of 2013).
Even if non-competitive pressures contribute to bottlenecks, I believe that the recent spate of outages is only symptomatic of a persistent supply glut. Thus, it could take years for logistical infrastructure to catch up, or perhaps it never will. Oil and gas gathering pipeline projects are often completed after peak production of a given area. Furthermore, central pipelines and expansion projects are time and cost-intensive, subject to numerous regulatory and environmental hurdles. Even if a major project makes it past FID, it can take years for it to become operational.
For example, Petronas scrapped plans to build a multi-billion LNG plant on Canada's Western shoreline earlier this summer. The grand vision is that LNG will one day create a global natural gas price. Future LNG projects on Canada's Western Coastline are expected to narrow the basis between WCSB benchmarks, lift producers prices (thereby unstranding stranded gas), and lower global energy prices. The economics of these immense projects are based on persistent discounts of Canadian benchmarks to global gas prices. Petronas' early withdrawal was likely influenced by persistent delays and over-runs of the much smaller Woodfibre project. It is likely that many off-take agreements which were made in anticipation of this deal will result in malinvestment, thus casting opacity on the future competitiveness of Canada's LNG industry.
Efficiency gains in the Montney are primarily responsible for the influx of new supply. According to a Canadian government press release last January, Montney wells costs have been falling while per well production has been rapidly rising due to an industrialized development approach which takes advantage of multi-pad drilling and continuous improvement practices. The source cited that average well production rates peaked at 3,500 Mcf/d in 2016, the highest rate so far.
Source: Government of Canada - National Energy Board. Canadian Energy Dynamics: Review of 2014 - Energy Market Assessment. Figure 10 Montney Natural Gas Production. February 2015.
Judging from recent well results, 2017 may be another record year. Encana (ECA), the Montney's largest operator, posted monster IP180 rates approaching 1,200 boe/d (~7,200 mcf/d).
Figure 6: ECA Top Well Results
Source: Encana Investor Relation. Montney Update - April 2017.
On the surface, it appears that negative pricing may be a short-lived phenomenon. Deeper inspection indicates the current imbalances may systemic and likely to persist longer than the market currently believes.
Canadian Natural Gas: Opportunity or Anathema?
Whatever the reasons for very low prices, the short run is going to be painful for gas-weighted upstream producers. Very low pricing will cause many wells to go into early hibernation this winter. Shut-ins hurt the bottom-line in two ways: foregone revenues and higher plugging and abandonment costs.
Even though the near-term looks bleak, negative prices could be a strong counter-cyclical indicator. Although producers in WCSB have previously proven to be exceedingly resilient to previous market price signals, none have been as severe. In theory, extreme prices should warrant an extreme response by both upstream (to shutter in the short-term) and midstream (to grow over the long run). The ensuing rationalization should result in more favorable market conditions (i.e., narrower basis differentials) going forward. As mentioned earlier, upstream rationalization is expected to occur rapidly while midstream expansion could take a while.
Moreover, negative prices can be seen also as a strong contrarian indicator for a bottom in equities valuations. By most measures, equities of Canadian producers are already exceedingly cheap compared with those within the continental United States, potentially creating favorable entry points into distressed assets at a cyclical market bottom. While valuations could always become even more depressed, investors could benefit from favorably skewed upside if and/or when things do not turn out as poorly as implied by market prices.
Regardless, upstream investors may wish to tread lightly in the WCSB since it is currently unclear as to how long the current imbalances and logistical issues will last. If anything, extraordinary market conditions favor infrastructure plays. Very low prices mean that:
- Logistical hubs can sell gas for next to nothing and still make a return.
- Central pipeline companies (e.g., TransCanada (TRP), Spectra Energy Partners (SEP), Pembina Pipeline Corp (PBA), Plains Midstream (PAA and PAGP), and others) can command higher prices and commitment volumes from producers.
- Processing facility providers, like Alta Gas (OTCPK:ATGFF), will remain in high demand from producers requiring price uplift.
Additionally, traders may find that extreme pricing opens up unique opportunities for arbitrage and risk-taking. The basis differentials between various Canadian and U.S. hubs seem favorable to the "storage and carry" trade which previously became common in 2014 when the term structures of WTI crude oil futures acutely favored storage in offshore vessels.
In my previous article, I committed to writing more frequent upstream investment ideas, specifically because I was beginning to see value especially in Canada. As I recently checked gas prices (for modeling purposes), I recoiled in disbelief to see AECO/NOVA prices had gone negative. Though I had previously learned that regional electricity prices can go negative due to regulations which prohibit wastage of excess power, I am still baffled by the mere existence of negative commodity prices.
The bottom line is that if very low AECO prices are a short-lived phenomenon, underappreciated stocks of companies like Painted Pony Petroleum (OTCPK:PDPYF), Tourmaline Oil (OTCPK:TRMLF), Seven Generations Energy (OTC:SVRGF), and others represent a compelling value. Unfortunately, the path towards a sustainable rebalancing of supply and logistical capacity remains unclear.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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