T?he U.S. natural gas market is entering a period of unparalleled risk and opportunity, when certain key trends will reshape the industry. Later this year, when the final leg of the Rockies Express (Rex) Pipeline is completed into the Ohio Valley, gas suppliers in the Rockies will be able to compete directly against supplies from the Gulf Coast and Appalachia.

Download the Gas Flow Appendix (PDF)

At the same time, U.S. gas production continues to increase, filling pipeline capacity out of major supply areas. And if this is not enough, the recession that began in 2008 is taking a toll on U.S. gas demand, creating an even greater disparity between supply and demand in key regional markets.

These developments will have significant implications for gas flows, capacity utilization and pricing differentials for years to come.

The triggering event for this market shift is completion of Rex into two major gateways to the Northeast: to the Lebanon Hub in Ohio in June, then across the state into the Clarington, Ohio, hub by November. This capacity of 1.8 billion cubic feet (Bcf) per day will fulfill Rex’s purpose of giving Rockies producers direct access to Northeast gas markets.

By extending the pipeline to Clarington, the pipeline avoided highly restrictive capacity bottlenecks at Lebanon, gaining access to nearly 5 Bcf a day of capacity on several pipelines serving the Northeast, including Dominion, Texas Eastern (Tetco), and Tennessee Gas Pipeline (TGP). Of this total capacity available at Clarington, an analysis of historical flows and capacity utilization at the hub indicates that about 0.9 Bcf a day is open and available to shippers during the winter season.

Unfortunately, pipeline-capacity constraints downstream of Clarington between the Ohio Valley and the large, premium-priced markets in the Northeast severely limit the usefulness of this new capacity. With downstream capacity constrained, the key implication is that, for Rex gas to capture market share in the Northeast, gas supplies that have traditionally served this region must be displaced. The most significant volumes of these competing supplies are sourced from Gulf Coast and Midcontinent wells.

Rex gas supplies have two distinct competitive advantages in this fight for market share. First, the pipeline’s tariff provides variable transportation-cost advantages to Rex shippers, primarily in the form of low fuel costs, relative to competing pipelines into the area. Second, these shippers are able to exploit the historical weakness of Rockies gas prices to compete aggressively with higher-priced Gulf supplies. The result will be significant gas-on-gas competition at the Clarington Hub and surrounding markets, with Gulf Coast suppliers being forced to either lower their prices or find alternative markets for their gas.

New Problems

Gulf producers face another problem, and it’s a big one. This upcoming displacement was fully anticipated by the shippers on Rex when the project was being developed several years ago. What was not anticipated was the astronomical growth seen in shale and tight-sands plays in competing producing regions.

In the early days of Rex development, Gulf-area production had been on the decline for several years, and the industry readily assumed the decline would “make room” for Rex gas to move into the lucrative Northeast marketplace. However, the unconventional shale and tight-sands plays happened, riding a wave of new drilling and completion technologies.

The impact of these new booms is still under way. Gas production continues to increase from the Haynesville, Fayetteville, Barnett and Woodford shale plays, despite weak commodity prices, reductions in capital availability and cuts in drilling budgets. In Appalachia, a similar situation is apparent in the Marcellus shale—although rig counts are down, the remaining active rigs are concentrating on areas with high rates of initial well production, effectively offsetting the impact of reduced drilling.

At the same time, several large pipeline projects serving Gulf Coast shale and tight-sands plays, including Gulf Crossing, Midcontinent Express and Texas Gas Transmission’s Fayetteville and Greenville laterals, have been or will soon be completed. These projects are designed specifically to move growing volumes eastward into the core Southeast/Gulf region, where they can access long-haul pipelines up to the Northeast. The catch is that pipeline capacity out of the Southeast/Gulf is itself starting to reach the limits of available capacity.

Growing production is filling the new pipeline projects into the Southeast/Gulf almost as soon as the projects are placed in service. This development, combined with lower demand in the region due to the economic recession, suggests that capacity on pipelines out of the region could soon be fully utilized for much of the year. The largest and most significant of these pipelines serve as the same sources of traditional supply into the Northeast—that will be competing head-to-head with Rockies gas flowing east on Rex.

Eye of the Storm

As rapidly growing shale and tight-sands volumes collide head-on with pipeline flows displaced by Rockies supplies on Rex, the epicenter of this storm will not be in the Northeast, or even in the Ohio Valley. It will be at Henry Hub in South Louisiana, the reference for all basis transactions in North America.

Most of the pipelines affected by Clarington displacements and burgeoning Southeast/Gulf supplies interconnect at or near Henry Hub. By creating direct competition between Rockies and Gulf production, the longstanding and continuing price weakness in the Rockies will put direct downward pressure on pricing at Henry.

Traditional regional pricing relationships can be expected to realign to reflect the combined effect of interregional price competition and a shift in the relative value of gas at Henry Hub.

Gas-flow shifts and resulting price realignments will tighten price spreads across the competing supply areas. The result will be a flattening of price basis across a broad swath of the North American gas market, from west of the Ohio Valley, extending to the California border and south to the Gulf of Mexico. Price differentials between many pricing points will narrow to the incremental cost of transporting gas from one location to another for some time to come.

It is somewhat ironic that relative price weakness at Henry Hub is expected to maintain positive Appalachian Basin basis differentials, as production continues to grow in the Marcellus and other Appalachian shale plays. Although the competition among Rex shippers, Gulf suppliers and Appalachian producers in Ohio will put downward pressure on Ohio’s historical price premium, the gas-on-gas competition in the Southeast/Gulf is expected to keep Gulf prices low enough that the price spreads between the Gulf and Ohio will cover variable transportation costs from the Gulf.

Relative prices at points east of capacity constraints in the Northeast will continue to exhibit high basis differentials. Today, many of these expected pricing developments have yet to be reflected in forward basis markets.

Expected Winners

There are a number of pipeline projects planned in the race to debottleneck constraints downstream of Clarington and to drive growing supplies deeper into the Northeast. Of nine key projects with potential to serve Northeast demand and to bridge across longstanding pipeline constraints, Tennessee’s 300 Line Expansion Project and Tetco’s Time III-Temax project are likely to have the greatest market impact, but not until 2010-12.

Currently, 12 underground gas-storage expansion projects are planned for the Northeast between now and 2012. These are expected to add 89 Bcf of working gas capacity, 2.5 Bcf of daily injection capacity and 2.9 Bcf of daily withdrawal capacity.

Projects with more attractive economics and better expected rates of return are those planned to be closest to major Northeast markets, downstream of key pipeline constraints and with planned interconnects to some of the new pipeline projects that will bridge past other major delivery constraint points. These top winning projects include Inergy’s Thomas Corners and U.S. Salt projects, and Dominion’s USA storage project.

Lower-value projects are those planned for areas upstream of regional pipeline choke points and that will exacerbate capacity constraints at those locations.

Clearly, the scenario described here implies lower gas prices due to production increases, new market competition and lower demand. Should prices drop low enough for long enough, production will begin to fall off.

On the demand side, economic recovery can also be expected to do its part to restore equilibrium to the supply-demand imbalance. Either or both of these developments would mitigate the market consequences described here.

However, two fundamental market changes will not be reversed. The first is new pipeline capacity that will create market competition where it has not existed before. The second is rapidly advancing production technology, making it possible for the industry to generate more supply at lower costs. These developments will have a profound and permanent impact on gas-pricing relationships across North America.

E. Russell (Rusty) Braziel is a managing director of consulting firm Bentek Energy LLC, which analyzes market factors pertinent to U.S. gas markets and infrastructure.