# Presentation: 486509

## The Herculean Challenge Facing Local Distribution Companies and State Regulators in Storage over the Next 4800 Hours

- by Andrew D. Weissman
- Chairman, Energy Ventures Group
- aweissman@energyvg.com

- Washington, D.C.
- April 10, 2003

- National Renewable Energy Laboratory
- Energy Analysis Seminar

## Andy’s Background

- Power industry specialist
- First 25 years of career as attorney
- Founding member of Swidler, Berlin, Shereff & Friedman
- Subsequently headed Morrison & Foerster’s D.C. Energy Practice Group
- Currently Chairman of Energy Ventures Group
- Investment firm / publisher of Energy Business Watch
- Offices in Washington, D.C., San Francisco and Houston
- Manages hedge fund + leading role in bringing cutting edge technology and new service models to  energy industry
- Helped to pioneer market for purchase and sale of SO2 emission rights in early 1990’s
- Structured virtually all of the early deals
- Includes first publicly announced SO2 allowance sale ( TVA / Wisconsin Power & Light) + first industrial deal (for Alcoa)
- $150 million+ in total transactions

## Overview of Presentation

- Two major areas of focus:
-      1. Near-term crisis that erupted in late February
-           - All time record prices at Henry Hub/NYMEX futures/City Gate
-             delivery point in East
-           - Record withdrawal from storage/record low end-of-winter levels
-       2. Early warning signs of a deeper, more lasting problem:
-            - Serious mismatch between supply and demand
-            - Likely to persist for at least 5 – 7 years
-            - Results from *combined* impact of aging of U.S. fields + sharp
-               increase in use of natural gas to generate electricity
-            - *Major* repercussions for energy industry + U.S. economy
- Severity of problem _not_ yet widely understood:
-       - Prices likely to rise _far_ higher than currently anticipated
-       - Far reaching impacts on U.S. energy companies + investors
-       - Could prove to be most important challenge facing U.S. economy
-         during this decade

## Astounding Deterioration in Storage

- All time record withdrawal
- 1.693 BCf in 10 week period beginning 1/3/03

## Not Attributable to Weather

- Attribution to cold weather = creative fiction.
-      - Return to norm, _not_ aberration
-       - On balance, still slightly **milder** than normal
-       - Could have been **significantly** worse
**Cumulative Heating Degree Days**
**November 1, 2002 through March 31, 2003**
**(Gas-Weighted HDD’s)**
**                                                                                                                                                                                                  **
**                                                                                                          ****Difference****                                                                                                              **
**                                       **_**District**_**                               **_**HDD’s**_**             **_**from Norm**_**      **_**% Difference**_
-                                     New England	             4,977 HDD’s        + 126 HDD’s          +   3%
-                                     Mid-Atlantic	             4,859 HDD’s        + 229 HDD’s          +   5%
-                                     East North Central            5,014 HDD’s         -  96 HDD’s	        -    2%
-                                     West North Central           5,023 HDD’s         - 314 HDD’s	        -    2%
-                                     South Atlantic	             3,063 HDD’s        +   34 HDD’s           +   1%
-                                     East South Central           3,047 HDD’s        +     2 HDD’s           +   1%
-                                     West South Central          2,077 HDD’s         -   71 HDD’s           -    3%
-                                     Mountain	             3,770 HDD’s         - 866 HDD’s           -  19%
-                                      Pacific	             _1,568 HDD’s_         _- 701 HDD’s_           _-  31%_
-                                      U.S.	             3,698 HDD’s         - 150 HDD’s           -    3%

## Largest Withdrawal Ever

- *  If climatologically normal winter
- ** If temperatures identical to ’00/’01 winter heating season

- Average of
- previous 8 winters

## What Explains?

-  Seven primary drivers:
-   1. _Return to more normal winter temperatures_
-       - Recent winters have been unusually mild last 3 out of 4 years
-       - ’01/’02 _particularly_ mild
-       - Accounts for much of the build-up in storage during ’01/’02 winter
-         heating season
-       - Masked emerging structural deficit
-   2. _Steep drop in U.S. production that began in Q1 of ’01_
-     - Results from combination of accelerating decline rate + sharp cutback in
-       drilling
-     - 2003 production will = lowest in 16 years
-     - At least 7.5 – 10% *below* 2000/2001 levels
-     - Little prospect for recovery soon
-     - Huge ramp-up in drilling required just to half continuing decline in supply
-     - Industry to have reached tipping point in production from conventional
-       on-shore + near shelf wells

## Causes (cont’d)

-  3. _Continuing rapid growth in use of natural gas to generate electricity_
-     - Growth _far_ more rapid than many analysts realize, due to anomaly in how
-       EIA classified natural gas use by Independent Power Producers and
-       industrial co-generators prior to until recent report
-     - While more a factor in summer than winter, growth in demand particularly
-       strong in regions with significant electric heating load (e.g. Florida,
-       Southeast, Southwest, Texas)
- 4. _Rapid growth in number of gas-heated homes_
-     - Could be adding as much as 1.5 – 2.0 BCf/day to demand this winter
- 5. _Declining imports from Canada_
-     - Results from parallel declines in production in Alberta, cutback in
-       Canadian drilling + increasing Canadian consumption
-     - Strongly exacerbated by severity of this winter in Canada
-     - Not even on radar screen 3 months ago
-     - But – could prove significant factor throughout remainder of this year

## Causes (cont’d)

- 6. _Increased exports to Mexico_
-     - More of a factor in summer, but still contributes
- 7. _High Prices/low availability of residual fuel oil and distillate_
-     - Secondary factor at best

## Fundamental Drivers of Emerging Mismatch Between Supply and Demand

## Tectonic Plates

-  Train wreck that began this winter stems from collision of two
-    tectonic plates set in motion long ago:
-  1. After several decades of development, production from most
-      conventional on-shore fields in U.S. and Alberta + Near-Shelf
-      region in Gulf has begun to enter period of _rapid_ decline
-       - _Not_ possible to reverse
-     - Even deepwater production expected to peak in ’04
-     - Coal bed methane + shale at best will barely offset continuing
-       declines from other sources
-  2. Shift to natural gas as near-exclusive fuel to meet incremental
-      electricity needs of U.S. economy
-       - Delayed impact of Clean Air Act requirements enacted long ago
-         (_viz.,_ Clean Air Act Amendments of ’77 and ’90)
-     - Strongly favors construction of new gas-fired generation
-     - Results in rapid increase in underlying rate of demand for
-       natural gas

## Irreversible Decline

## Barriers to Increased Production

- While higher prices in ’00 and early ’01 resulted in massive increase in drilling, total U.S. production barely budged
- Maximum increase achieved = 1.4 BCf/day ( i.e, 2.7%)
- Early warning sign of crisis to come
- Correlates with _massive_ increase in expenditures for development
- Every reason to assume E & P companies used resources efficiently
- Further depleted inventory of attractive targets for new drilling
- No reason to believe will be easier to expand production in ’03 or ‘04

## Causes

- Results from combined impact of:
-      1. Rapid increase in decline rate
-           - i.e., loss in production from existing wells
-      2. Sharp fall-off in size of typical new well
-           - Requires drilling _far_ more wells to achieve any given increment
-              in production
-       3. Steep drop in half life of typical new well
-            - In 2003, typically less than 12 months
- Net impact:  in 2003, may need to drill up to 18,000 new development wells just to replace loss in production from existing wells
-       - Equates to natural gas rig rate of 900/month

## EOG Resources Estimates of U.S. Production

## Other Factors

- Exacerbated by:
-      1. Sharp increase in exports to Mexico
-      2. Unexpected decline in imports from Canada (especially this
-          year)

## Abrupt Shift in Source of Fuel to Meet Incremental Electricity Needs

## Time Bomb Lurking

- Demand for electricity generally increases _every_ year
- even during recessions
- ’01 = only third year in past 25 in which total electricity use has declined
- Even in ’01, decline _still_ = only 0.2%
-       - _Despite_ most severe manufacturing recession in 22 years +
-         extremely mild weather and September 11th terrorist attacks

## Incremental Electric Generation(’89 – ’97)

- For most of 1990’s, incremental electricity needs could be met primarily through increased use of existing coal and nuclear capacity:
- Sources of Incremental Generation

## Vast New Construction Program

- More than $100 billion of gas-fired capacity brought into service since 1999 or under construction now
- Enough new generation to serve more than 1⁄2 of Europe

| Year | Additions | Total Gas-Fired Generation | % of Total U.S. Capacity |
| --- | --- | --- | --- |
| 1999 | 22,641 MW | 201,979 MW | 25.4% |
| 2000 | 25,527 MW | 227,506 MW | 27.7% |
| 2001 | 40,386 MW | 267,892 MW | 31.0% |
| 2002 * | 67,982 MW | 335,874 MW | 36.0% |
| 2003 * | 54,158 MW | 390,032 MW | 39.6% |

**Total Additions = 210,694 MW**
- * Includes plants currently under construction but excludes all planned additions  that have not yet broken ground.

**Gas-Fired Capacity**

##  U.S. now dependent upon expanded generation from gas-fired units    for many years to come:                                                                   Sources of Incremental Generation

_**Incremental Electric Generation**_**  **_**(1997-2020)**_

## 30 TCf Scenario No Longer Realistic

- Growing belief within E & P industry that 24.0 – 25.0 TCf/year may be difficult to achieve

## Time and Price

## Potential Catastrophy Looming

## No Physical Shortages

- Despite huge gap between supply and level of demand expected at current price levels, physical shortages, _not_ likely to occur
- Instead, market _will_ clear
- Issue = strictly lead time required to develop new supplies + price
- Remaining conventional development targets tend to be:
-      - _Much_ smaller
-      - Inferior quality
-      - Deeper
-      - Significantly more costly to develop
- Until new, larger scale, non-conventional projects come on line, upward price pressure could be intense
-       - Far longer lead times

## Far Longer Lead Times

- To obtain larger supply increments needed to balance between supply and demand, necessary to pursue large scale, non-conventional projects with higher costs and longer lead times
**New Sources**

| Source | Required Capital Expenditures | Required Lead Time | Likely Increase in Supply |
| --- | --- | --- | --- |
| Mackenzie Delta in Canada (near Arctic Circle) | $8.5 -10 billion | At least 4-5 years | 1-2 BCf/day
 |
| Prudhoe Bay | Comparable magnitude | Similar | Comparable |
| Ultra -deepwater platforms in the Gulf (i.e., 15,000-20,000 foot depth) | $500 million or more per platform | 4-5 years | 0.5 BCf/day |
| LNG | $250 million per tanker for new tankers; $0.5 billion or more for new delivery terminals if it is possible to site after September 11th attack. | Likely to be at least 2006 or 2007 before imports of LNG into the U.S. can be increased significantly | <0.5 BCf/day over next 2 years |

## Safe Levels ?

- Earlier planning goal = 2,800 – 3,000 BCf total storage by end of Refill Season
- This level = 2,300 BCf (prior all-time record) + 500 – 800 BCf reserve
- Helped to protect against potential for:
-      1. Continued growth in demand
-      2. Even colder winter
- Also helped to ensure that, even if large withdrawal occurred, would enter next withdrawal season with storage targets at least partially satisfied.

## How Much is Adequate ?

- Simply to allow for a repeat of ’00/’01 winter temperatures requires at least 3,121 BCf:
-                              2,536 BCf (peak to trough)
-                        _+       585 BCf (adj. for temperature differential)_
-                              3,121 BCf Required Minimum
- Even this figure, however, does not take into account
-      - Need for a safety margin
-      - Likelihood of significantly lower Canadian imports (especially in
-        Q4 ‘03 vs. Q4 ’02)
-      - Expected continued increases in exports to Mexico
-      - Potential for continued increases in power-sector, residential and
-        commercial
-      - Need to end withdrawals season with reserves above zero

## New Tote Card

- Maximum current capacity = 3,450 BCf
- Need _far_ exceeds this level:
-      ’02/’03 Withdrawal Adj. to match ’00/’01 weather             3,121 BCf
-      Likelihood of Reduced Canadian Imports                            125 BCf
-      Likelihood of Increased Exports to Mexico                             75 BCf
-      Potential Increases in U.S. Demand                           125 - 250 BCf
-      Sub-total                                                               3,446 – 3,571 BCf
-      _Safety Margin                                              _         _    500 -    800 BCf_
-      **Reasonable Planning Target (if adequate        3,946 – 4,371 BCf**
**        ****capacity were available)**
**     ****Deficit in Total Storage Capacity                         496 –    921 BCf**

## Severe Crisis Brewing

- Bare minimum needed to be safe for next winter = 3,200 – 3,400 BCf:
-                      Winter temperatures ’00/’01         3,121 BCf
-                      Reduced Canadian Imports             125 BCf
-                      _Increased Exports to Mexico              75 BCf_
-                                                                             3,321 BCf
- Does not include _any_ allowance for:
-       - Potential further deterioration in U.S. or Canadian production
-       - Potential further increases in U.S. demand
-       - Potential limitations on availability of fuel oil or distillate
-       - Need to start Refill Season with storage above zero

## Not Clear Attainable

- Not clear can be achieved
- Total injection last year = only 1,681 BCf
-       - Would result in end-of-Refill Season storage of only 2,361 BCf
-       - 1.0 TCf short of bare minimum goal
- Compared to last year:
-       - _many_ factors have deteriorated
-       - only a few have improved

## Deteriorating Factors

- Compared to Q2 and Q3 of 2002, U.S. production likely to decline at least 0.50 - 0.75 BCf/day
-      - Increases due to Kern River expansion and Canyon Express not
-        sufficient to offset continued declines in most other fields
- Canadian imports likely to decline at least 1.0 – 1.5 BCf/day
- Exports to Mexico likely to increase 0.5 – 0.75 BCf/day
- Q2 power-related natural gas consumption in Eastern U.S. likely to increase by as much as 1.0 – 2.0 BCf/day
-      - Combination of NOx requirements and anemic 2002 comps
- Q2 and Q3 power-related natural gas consumption in Western U.S. likely to increase by as much as 1.5 – 2.0 BCf/day
- Oil prices likely to be at least as high as last year
- Inventories of distillate and residual fuel oil near record lows
- New supplies likely to remain tight

## Potential Pluses

- LNG imports could increase by up to 0.5 BCf/day
- Industrial consumption appears to have fallen by as much as 1.0 – 1.25 BCf/day
- Summer weather might not be as hot
-       - But likely to be largely offset by NOx requirements in the
-          Northeast and poor hydro availability in the West
- At least on paper, substantial fuel switching capability still remains, especially in the power sector
-       - Could be as much as 5-7 BCf/day
- Degree to which fuel switching will occur, however, is a very different issue

## First Cut Comparison to Last Refill Season

- Prior to any additional fuel switching or other “demand destruction”, likely injection this year appears to be significantly _below_ 2002:
-           _Deteriorating Factor_
-           Production Declines                                       0.50 – 0.75 BCf/day
-           Reduced Canadian Imports                           1.00 – 1.50 BCf/day
-           Increased Exports to Mexico                         0.50 – 0.75 BCf/day
-           Poor Hydro availability in West (assuming               1.00 BCf/day
-           _ __mild summer)                                   _              _________________
-           Sub-total                                                         3.00 – 4.00 BCf/day
-            _Improvements             _
-            Additional LNG Imports                                            0.50 BCf/day
-            _Reduced Industrial Consumption                  1.00 – 1.25 BCf/day_
-            Sub-total                                                        1.50 – 2.50 BCf/day
-            Net Deterioration                                           1.25 – 2.50 BCf/day

## Huge Gap

- Results in even larger gap:
-         Last year’s injection                                          1,681 BCf
-         Less Adjustment for deterioration (i.e.,    - 250 – 500 BCf
-         1.25 – 2.50 BCf/day x 210 _days in _
-         _Refill Season)_____________________________________
-                                                                       1,181 – 1,431 BCf
- Would result in all-time record low end-of-Refill Season storage
-      entering into next withdrawal season:
-          Current storage levels                                          680 BCf
-          _Projected Refill            _                         _1,181 – 1,431 BCf_
-          End-of-Season Total                            1,861 – 2,111 BCf
- Potentially disastrous scenario
- Less than actually withdrawal between 12/02 and 3/14/03

## Factors That Could Limit Fuel Switching

- Economics
- Near-term economic _dis_favor fuel switching
-      - Critical factor, since largest injections typically occur in April and
-         May
- In addition, many other factors could limit extent of fuel switching
- These includes:
-       1. Permit limitations
-       2. Equipment limitations/need to switch burners
-       3. Lead-time required to cancel supply contract and/or enter into
-           new arrangements
-       4. Limited supplies of distillate and residual fuel oil
-       5. Risk that any significant amount of switching will quickly cause
-           shortages and/or erase any benefit from switching (as reflected
-           in recent stickiness of prides for distillate and resid)
-       6. Extensive hedging by most price sensitive industrial
-           users/reluctance to default up on performance obligations

## Factors That Could Limit Fuel Switching

-      7. Potential cost of emission credits associated with burning oil
-      8. Lack of incentive on part of electric utilities or other generators
-          allowed to flow through fuel costs
- Suggests high likelihood that only a small fraction of theoretically potential for fuel switching actually will occur, at least until natural gas prices rise to significantly higher levels on a sustained basis
-       - In all likelihood, will require prices well above $8.00/MMBTU for
-         at least 6-8 weeks to prompt maximum feasible fuel switching
-       - Even then, may take 60-90 days until decisions fully implemented

## Market Dynamic

- Buyers who most value natural gas use _and_ have financial wherewithal to bid up prices will pay _whatever_ _is_ _necessary_ to drive others users out of market and balance supply and demand
- If necessary to satisfy customer needs, generators and LDC’s capable of bidding _very_ high
- Residential and commercial demand also relatively elastic
- Suggest prices could reach new, far higher plateau and, on average, remain at theses levels for many years

## Obstacles to Obtaining Further Reductions in Use

## Rapid Decline in Industrial Use

- Industrial use has declined dramatically
-       - _Far_ less load available to decrement
- Most industrial load almost certainly far less price sensitive
-       - Still using despite two steep run-up’s in price
-       - Naïve to believe will quickly decrement at $4 or even $6/MMBTU

## Price by Power Sector

- During same period, use of natural gas at generating units has occurred
- NOx trading program may increase demand significantly
-      - Effective 05/01/03 in 12-state region in northeast

## Far Less Price Sensitive

- Industrial use now = less than 25% of total demand
- Load that remains far less sensitive to price

- * Excludes use of natural gas by Independent 	Power Producers to generate electricity

## Implications

- Sets stage for intense upward price pressure as amounts in storage rapidly drawn down
-        - Bidding war for scarce supply, _not_ normal adjustment process as
-           supplies tighten
- No precedent for mismatch of severity or duration likely to occur this year
- Key differences between ’03 vs. period beginning Q2-3 of ’00:
-      1. Deficit _much_ larger
-          As a result, U.S. now dependent upon increased use of natural  gas to meet virtually all of the incremental energy needs of U.S. economy
-           - i.e., 5 – 7 BCf/day in ’03 vs. 2.25 BCf/day deficit in ’00
**     **

## Implications (contd)

**    **2.  Significantly less industrial load available to decrement
-     3.  _Not_ possible to quickly offset deficit solely by increased
-          drilling from conventional wells

## How to Contact Andy for Questions

| Mailing Address: | Andy Weissman
Energy Ventures Group, L.L.C.
3050 K Street, N.W.
Suite 205
Washington, DC 20007-5123 |
| --- | --- |
| E-mail: | aweissman@energyvg.com |
| Office Phone: | 202/944-4141 |
| Cell: | 202/744-1956 |
| Fax: | 202/944-4145 |
| URL’s: | www.energyvg.com                               www.energycentral.com
www.energybusinesswatch.com            www.energypulse.net
www.fswx.com
www.eia.doe.gov
www.cpc.ncep.noaa.gov
  |