The price of Western Canadian Natural gas is getting hammered. At one point last Thursday, a gigajoule of natural gas was trading for only $C 0.65 at Alberta’s AECO hub. By the end of the week it had recovered closer to $C 0.92. But that is still incredibly low. The last time the industry realized these price levels was during the 1990s.
Across the continent natural gas prices are depressed due to an exceptionally warm winter, competition with other primary energy sources and persistent high production rates. But AECO prices are especially weak with discounts to Henry Hub almost double what would be expected.
High volumes of domestic production and shrinking export markets are the catalysts for depressed AECO prices. Additional capacity on the regional NOVA pipeline system has unleashed a surge of new production this year. Compared with the final quarter of 2015, production is up 6% or almost 1 Bcf/d. Further amplifying the problem, pipeline flows into Ontario have been dropping off.
With nowhere else to go, the surplus gas is flowing into Western Canadian storage caverns that were already elevated from this year’s warm winter. Storage levels are currently about 70% higher than last year and, while there is still some spare capacity, the unusually high levels are making the market nervous and depressing AECO price.
Deep, sustained discounts from other North American price hubs are typically only possible when there is a lack of physical takeaway capacity. A textbook example occurred in 2012-2013 when Canadian crude oils were selling for giveaway prices due to a lack of pipeline capacity.
For Western Canadian gas, unlike oil, today’s price markdown is not caused by a lack of physical takeaway capacity. The largest natural gas pipeline leaving Alberta – the 50-year-old TransCanada Mainline – is about half empty.
The issue is an economic barrier. The cost for transporting gas from Alberta to the heart of the Ontario market is near $C 2.00/GJ. But with the price in Ontario at about $C 2.40/GJ, AECO price would need to approach 40 cents before the economics of flowing gas would work. Transporting molecules to closer delivery points helps. For example, fees for sending gas from Alberta to the US border near Emerson are cheaper, but ultimately still require almost a $C 1.00/GJ discount for AECO. With these high tolls, it is as if the Mainline pipeline is shut off.
Beyond the immediate pain of today’s low AECO prices, it is worth thinking about the longer term implications of the high Mainline tolls. High transportation costs mean that Western Canadian producers cannot compete with American suppliers into Eastern Canada. With more US to Ontario pipeline connections being added each year, the competition is only intensifying. Canadian market share will decline as a result.
The lack of discussion on the implications of Eastern Canada becoming more dependent on US supplies is somewhat puzzling, especially when you contrast it to the conversation surrounding the proposed Energy East crude oil pipeline, where a bright light is shining on the energy security and economic benefits of using Western Canadian crude oil in Eastern Canada.
Returning back to the near term issues at AECO. How will today’s low prices be fixed? There are a few market mechanisms that will help to iron out the price distortion between AECO and other markets in the coming months.
One solution is lower production. At under a $C 1 a gigajoule most natural gas producers are hard pressed to cover off their cash costs, including services for keeping wells operating, processing costs and transportation tolls. These poor financials make shut-ins likely. In the spring of 2012, when a similar situation occurred, Western Canadian production was squeezed down by 1.5 Bcf/d.
The second mechanism is higher flows on the Mainline. At today’s depressed prices, the economics of shipping natural gas on the Mainline from Alberta to closer delivery points ̶ like Emerson ̶ start to work. In order to lock in the transportation rates, buyers must enter into one year agreements. Already over the past month, a number of fresh agreements have been inked. These deals will boost flows and help AECO prices over the next 12 months.
One could argue that today’s situation of warm weather and high production is unique. However, growing competition from US suppliers into Canada’s traditional markets means that periods where Canadian production outstrips downstream demand will happen more frequently than in the past, making the AECO price volatile as a result.
Even though the market will always find ways to sort out inefficiencies and restore pricing, as it will over the next few months, today’s situation highlights an important question on the Mainline tolls. If the regulated toll on this monopoly infrastructure could be lower, higher flows on the pipeline would help clear gluts, and reduce volatility and discounts for Canadian natural gas. This would boost revenues, and increase taxes and royalties through higher wellhead prices and production.
Changing the Mainline tolls is not an easy issue. With over half of the toll going towards paying down the deprecation charges, it raises the thorny issue of deciding who will pay for these past expenses. Nor is the question new. It has been studied many times. The most recent decision from the regulator came about one year ago, fixing the rates to 2020. Despite these challenges it is worth revisiting. It is time for a creative solution that would benefit Canada.