Those Exploding Gas Prices

Drilling hasn't begun to keep up with demand

Philip Flynn is staring at his computer screen in disbelief these days. The energy analyst at Chicago-based Alaron Trading Corp. watched the price of natural gas nearly double in three business days, hitting $9.70 per million Btus at the New York Mercantile Exchange on Feb. 25. That's four times what natural gas cost at this time last year. That's not the worst: Spot prices for gas deliveries to Texas and New York hit about $25 per million Btus on the same day. "There have been entire years when prices haven't risen this much," Flynn says.

Between fear of war in the Middle East, an oil strike in Venezuela, and cold weather across the country, energy prices are surging across the board. But no commodity has risen faster than natural gas. While the price of oil is tied as much to foreign policy as it is to the number of drilling rigs in operation, the natural gas price spike is almost entirely a homegrown phenomenon. The problem: Even without the recent cold snap, the energy industry isn't producing enough gas. "The gas supply picture is just barely keeping up with demand," says Lee Gooch, chairman of the Process Gas Consumers Group, which represents large industrial consumers. "We've got a semi-crisis brewing, and it's going to take a while to turn that around."

Consumers are feeling the pinch. Although the three-day jump won't affect most buyers if it proves temporary, gas prices had already soared, rising from about $2.20 per million Btus in early 2002 to roughly $6 by early February. Half of all U.S. homes are heated by natural gas. The U.S. Energy Information Administration predicts that a typical residential customer in the Midwest will spend about $762 on gas this winter, a 28% increase from last year. Big companies are also getting hit. U.S. Steel Corp. Chairman Thomas J. Usher told investors recently that higher gas prices would cost it more than $50 million a year, a big part of why he has been seeking price hikes from carmakers.

Still, the natural gas industry and its customers aren't in quite the bind that soaring prices seem to suggest. A large reason for the price runup stems from a good old-fashioned Wall Street mini-panic. Traders who bet that the price would decline have had to buy gas to cover their short positions, putting sharp upward pressure on prices. Since most utilities and industrial consumers buy natural gas under long-term contracts, few will actually pay the recent astronomically high prices.

Nor is access to promising drilling rights the real problem. On the same day prices soared to record levels, energy executives testifying before the Senate Energy & Natural Resources Committee called for the federal government to ease restrictions on drilling, particularly on Alaska's North Slope, in the Rockies, and offshore on the East and West Coasts. But drilling restrictions hardly seem to have crimped the industry. Indeed, many companies have spent the past several years passing on new drilling opportunities. The reason: After a big price spurt in 2000 and 2001, most energy companies correctly predicted that gas prices would fall, in step with the weakening U.S. economy. Many cut back on developing new wells. The result: by some estimates, a 5% dip in U.S. natural gas production last year, the largest such decline in sixteen years.

Gas producers didn't expect that prices would recover so quickly in 2002. Despite economic weakness, demand stayed strong as new power plants fired by natural gas came on line. Such plants now account for a quarter of gas consumption, nearly twice their level a decade ago. That sent prices heading back up again, setting the stage for a big price surge when the weather turned unexpectedly frigid in the Northeast and Midwest.

The squeeze on supplies isn't likely to ease this year. Although the number of rigs drilling for natural gas in the U.S. has been creeping up, at 767 it is still 30% below the all-time high in July, 2001. Natural gas prices are expected to average well above $4 per million Btus this year, below current prices but still twice historical averages. "Normally, when you have prices this high, you see a big increase in drilling activity," notes Bruce Henning, a consultant with Energy & Environmental Analysis Inc. in Arlington, Va. "We haven't seen it."

What's holding up new drilling? Industry consolidation, for one. Recently merged entities such as ChevronTexaco Corp. (CVX ) and ConocoPhillips (COP ) have lower drilling budgets than the individual companies did pre-merger. Large producers such as ExxonMobil (XOM ) and BP PLC (BP ) are more inclined to merge and cut costs than invest the time and money to bring new fields on line. Says Paul Ziff, an energy consultant with Ziff Energy Group: "Those big fields take a long time to develop."

The collapse of the energy-trading industry has also hurt. Enron Corp. and others helped small energy companies raise capital by selling their future production under long-term contracts. Financial institutions such as Bank of America (BAC ) and UBS Warburg (UBS ) have entered the energy-trading business, but they tend to be more cautious, says Gary Ackerman, executive director of the Western Power Trading Forum, an industry trade group. "Few deals are being done, even though the timing is perfect," Ackerman says.

Banks, investors, and credit-rating agencies, meanwhile, are putting pressure on energy companies to reduce their debt and boost their returns on investment. "You've got a combination of people telling you: `Don't go borrowing money to drill,"' says John D. Schiller Jr., executive vice-president of exploration and production at Ocean Energy Inc., a Houston producer that recently agreed to sell itself to Devon Energy Corp. (DVN ), in part to take advantage of today's high commodity prices. Those cautious voices aren't likely to quiet down anytime soon.

By Christopher Palmeri in Los Angeles, with Stephanie Anderson Forest in Dallas, Michael Arndt in Chicago, Alexandra Starr in Washington, and Peter Coy in New York

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