• For only the second time in twenty years U.S. electricity generation declined last summer. Over the last two decades electrical use has grown an average of 2.4% per year. Most of the incremental gains in generation, if we resume the growth trend (which we should as the economy grows and we have a more normal summer weather-wise) will be supplied from natural gas generation units.

  A new report by Stifel Nicolaus predicts higher electrical generation utilization this summer will lead to higher natural gas prices- and potentially to price spikes. Data released this week by the Edison Electric Institute show that electricity generation nationwide was 6.6% higher than the same week a year ago – Stifel predicts generation gains averaging 3% this year.

   

• Bombings in Saudi Arabia and Iraq continue the trend of instability in the Middle East, a real worry since it supplies such a large share of the world’s crude oil. The attempted bombing of the offshore Iraq export facilities last weekend targeted 1.9 million barrels per day of export capacity – a sizeable amount in the world oil market. This interruption would have had significant impacts on prices if it had been successful. Higher crude oil prices mean that fuel switching from natural gas to oil in the U.S. will be minimized. Since crude oil and natural gas prices correlate relatively closely, we expect the price of both to remain above average.

   

• Demand for crude oil continues to grow, keeping prices strong. Note the acompanying graph of crude oil production and consumption in India provided by Raymond James & Associates.

  Until 1990 the increase in crude oil supply and demand generally tracked each other. Over the last decade the growth in oil demand has exceeded domestic Indian oil production which has remained flat. This trend is expected to continue.

  Indian demand as a percentage of global demand has increased from 1.8% in 1990 to 2.8% in 2000. Raymond James expects it will hit 3.0% this year as the Indian economy continues to expand.

   

• The risk premium for liquified natural gas (LNG) and crude oil is rising. "We have begun to focus on the potential of a disastrous maritime terrorist incident," Matthew Daley, Deputy Assistant Secretary of State, told a security conference last month.

   

• Energy takeover bids last month by EnCana and Kerr-McGee indicate that some companies in the energy sector find the future value of oil and natural gas reserves more valuable than the market prices of the target companies—a bullish sign for energy investors.

   

• Demand for crude oil from China (chart by FirstEnergy Capital Corporation) continues to accelerate with their economy. China was an exporter of crude oil as recently as 1991, but now it is a net importer and the level of imports continues to grow. China now represents about 6.7% of global demand.

  Recent statements from Chinese authorities claim they want to moderate economic growth, but any measures that are implemented will take some time to have an effect. Growth of energy intensive industries and automobile ownership in that country are expected to continue to grow briskly. International demands for crude oil have put upward pressures on prices.

   

• During the first years of the 21st century power companies have undertaken an unprecedented expansion of electric generating capacity. One expert noted that this building activity is “a truly historic mobilization of construction and managerial resources to bring about this tremendous physical plant expansion."

  Worldwide capacity additions completed or scheduled from 2000 to 2006 are estimated to be 906 gigawatts, of which 30% will be built in the United States and around 18% will be built in China.

  Due to environmental regulations in the United States most of these facilities will utilize natural gas, although some units to be completed in the next few years will burn coal as concerns grow about natural gas availability and price. Natural gas generating capacity in the U.S. over the last decade has risen much faster than those of alternative fuels, as can be seen in the chart prepared by Stifel Nicolaus.

   

• The Environmental Protection Agency, under the more stringent National Ambient Air Quality Standard (NAAQS) guidelines that were set for ozone, announced last month that 474 counties nationwide failed ozone pollution standards. Ozone is formed when volatile organic compounds (VOC’s) react with nitrogen oxides (NOX) to form smog—and sunny and hot days provide the energy.

  The implication of this finding is major—all these counties now have to adopt formal plans to reduce ozone formation by a given deadline. Simplified, liquid fuels emit VOC’s—so adding costly controls on liquid fuels is one way to reduce emissions and ozone formation.

  Natural gas does not emit VOC’s—so using natural gas by definition removes one of the smog precursors. The EPA restrictions will be another big incentive for consumers and businesses in these ozone non-attainment counties to increase their use of natural gas.

   

• The EPA will announce NAAQS findings on “particulates” this summer. Smog, formed from ozone, is a source of microscopic particulates. Regulations on particulates will also push energy consumers toward natural gas—either by mandate or by pricing signals. Particulate standards are also a problem for coal generating plants—and to a lesser extent diesel engines. Again, natural gas producers will benefit from demand increases.

   

• Rail transportation issues, increased demand from steel makers, and coal exports to Asia may impact U.S. electrical generation this summer by forcing coal fired generation plants to reduce output capacity. Any coal shortfall most likely will be made up by natural gas generating facilities.

  Peabody Coal's chairman and chief executive officer remarked that the low stockpiles could become a serious problem for the power generators because the supply of coal is tight, and getting on-time rail delivery has also become a problem. Train operators face service problems and delays due to derailments. A recovering economy has boosted demand for rail service, putting pressure on the industry. Consequently, coal power plants could find themselves running out of coal with no quick way to restock. Some coal power plants could have to cut back power output this summer to keep from running out of fuel. The CEO of Massey Energy had similar comments regarding the coal market.

  And an analyst with State Street Research in a recent Wall $treet Week interview mentioned a “possible coal shortage that we could be looking at later this year” giving it “about a 50-50 chance of happening, and maybe 100 percent chance of happening next year.” He concludes that “the ramification of that is you're going to have to burn more natural gas for making electricity if the coal plants don't have coal. And that's going to push natural gas prices up higher than anyone would like to expect.” We have no feel for the coal markets or the related transportation issues they face, but the individuals making statements regarding those markets appear credible.

   

• Western states are in the sixth consecutive year of drought, with portions of the usually verdant Rockies looking more like the Mojave Desert. In what scientists call a combination of drought cycles and global warming, nine Western states are seeing extreme dryness. Northwest River Forecast Center, a division of the National Oceanic and Atmospheric Administration, released a forecast last month predicting flows to be 79% of normal from April to September at The Dalles Dam on the California and Oregon border. Low reservoir levels will limit hydroelectric power generation in western states, putting more pressure on natural gas and coal units.

   

• The EPA is studying toxic mercury emissions from coal fired generating units and is expected to promulgate a rule later this year that will mandate utilities reduce such emissions under Clean Air Act provisions. Emissions from coal fired utility plants represent the single largest unregulated industrial source of mercury emissions in the U.S.

  The technology to reduce mercury emissions is not well developed, and whatever emission control mandates are implemented by the EPA will increase the cost of burning coal. While a longer term issue, this is another development that will increase the attractiveness of natural gas.

The more we look at current developments the more we are convinced that the prices of natural gas and crude oil will remain above normal levels this summer. We would be aggressive investors in this sector, focusing on the energy services sector.

Copyright 2004 CyberTech, Inc.

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