By Published On: February 10, 2006

Demand for natural gas is at its lowest level in six years, thanks to one of the warmest U.S. winters on record as well as high prices. Gas storage is at record levels for this time of year. Consequently, gas prices now are in free fall. The near-month contract closed yesterday at around $7.50/MMBtu, down 50 percent since December 13. The average contract price for the next 12 months is around $9.00/MMBtu, the lowest since last August. As we learned in Economics 101, prices are driven by supply and demand. Supply has been virtually stagnant for years. Meanwhile, prices have soared. Ergo, higher demand has been responsible for higher prices. (Consumption has not increased much, of course?you can?t burn supplies you don?t have.) Annual gas consumption for 2005 is projected to be the lowest since 1999. Now that demand has weakened, prices are dropping. The weather in January was absolutely balmy. Gas used for heating last month was 25 percent lower than the average of the prior seven Januaries, saving more than 350 billion cubic feet of gas in just one month, according to my model. This decrease, combined with the impact of hurricane damage last fall, more than offset the supply lost from the storms. By any measure, the U.S. has lots of gas on hand. The change in outlook since mid-December has been remarkable. How much lower can gas prices go? Although January weather was certainly an aberration, February has been especially mild, too. The end of the heating season is in sight, and storage will soon begin to build again to put additional downward pressure on prices. But gas prices have already dropped to 70 percent of crude oil prices on an energy basis, below the historical 75 percent support level. At today?s prices, gas is cheaper than residual fuel oil, and fuel switching from oil to gas will occur if prices drop below current relative levels. This would increase demand and create upward pressure on prices. Some respected analysts are now claiming that liquefied natural gas will flood the market and lower prices to the $4.50/MMBtu range by 2010. Perhaps they are right, but if so, I predict that gas consumption would soar and we?d be back to requiring ever-increasing amounts of gas to burn. Would this be progress? What really has my attention is not the unusual weather and price gyrations, but the fact that the U.S. has been able to prosper for the last six years with virtually no additional natural gas. We even weathered major disruptions caused by the hurricanes without shortages. The oil and gas industry thinks the answer always is more supply. But the last 12 months showed that our Econ 101 professors knew what they were talking about – prices respond to changes in demand as well as supply.

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