By Dave Forest, Posted Thursday, September 17, 2009

I mentioned last week that natural gas prices in the U.S. have been hitting multi-year lows recently. Over the past few weeks, we've seen spot gas and even front-month futures trade below $2/mcf. A level that many in the oil patch thought we would never see again.

One of the maxims in the oil and gas business has always been that oil is a global market while gas is local. Meaning that gas prices in different parts of the world don't necessarily track each other. We could see expensive gas in Asia at the same time that American prices are falling.

But the gas market is becoming globalized. Particularly because of the large build-out in liquefied natural gas (LNG) capacity over the past several years. LNG has given many natural gas producers the ability to ship their gas around the planet. These mobile supplies can "follow the money", going to markets where prices are highest. This tends to equalize prices, as high-price markets attract a lot of additional supply. Eventually all of this extra supply brings prices down. And if the price falls below that of other world markets, supplies are diverted elsewhere, helping restore the supply-demand balance and support prices.

But the increasingly globalized gas market is starting to play against producers. As I've discussed in the past, most of the LNG plants built over the last several years (and a number of major projects still currently under construction) were designed with the thought that the U.S. would be a "market of last resort" for produced gas. Project developers figured that if they couldn't secure a decent price in other markets, gas demand in America would always be strong enough to guarantee a profitable sale price. Based on this "fall back" market, many projects showed acceptable returns on investment and were given the green light for construction.

But things have changed. Shale gas developers in the U.S. have been so successful over the last few years that they have shifted the American gas sector from a seller's to a buyer's market. Simply put, America is today producing a lot of gas that no one ever expected. Which has driven U.S. gas prices to the decade-lows mentioned above.

And because of LNG this is not just a problem for American gas producers. With the U.S. gas market now largely saturated, the "buyer of last resort" is no longer taking many deliveries. LNG producers are looking elsewhere to sell their product. Which means a flood of supplies are landing in other markets around the world. The buyer of choice lately has been the U.K., where gas prices have been trading at a premium to U.S. contracts for several months. Six cargos of LNG are expected to land in the U.K. this month. This, despite that fact that increased LNG landings have begun to flood the British market and drive down prices. Traders now expect this coming winter to be one of the worst price-wise for British gas in several years.

Increased British LNG landings are altering the country's entire gas production profile. Gas production from the British North Sea is being crowded out. In fact, there are reports that some gas fields are being shut in, only being reactivated when brief price spikes make them profitable. This is a big change to supply dynamics in this region. Which will make it tougher for domestic producers going forward.

Dave Forest