ith a combination of warmer-than-normal weather and unexpectedly large supply growth, the current natural gasstorage overhang is running 714 billion cubic feet (Bcf) above last year's level. Taking into account this overhang and the near-term weather forecast, we estimate that storage should stand at about 2,220 Bcf at the end of March 2012.

Yet, many market participants are questioning whether it is possible to have storage at this level, given certain clauses within contracts that require storage users to draw down their volumes to a certain percentage of the contracted level. These are called "storage ratchets" and have introduced fear among market watchers who expect excess storage volumes to be dumped into the market at the end of the withdrawal season.

If this occurs, it would cause significant dislocations in spot gas prices. If the forced withdrawal was large enough, it would press prices down temporarily across the continent.

Storage providers put ratchets in place to protect their fields' operations. But many market watchers believe that these ratchets will force a significant amount of gas from inventory in March and April.

Confiscated volumes

Our analysis indicates that the storage system could physically hold at least 2.4 trillion cubic feet (Tcf) by the end of March, which means our forecasted 2.2 Tcf could still be achieved. However, there is a downside risk to our forecast, as about 10 out of the 27 companies surveyed by the Energy Information Administration (EIA) in 2008 have storage ratchets that would cause volumes in excess of ratchets to be confiscated. With that said, it is difficult to quantify the amount of gas that would be flushed out of storage as this withdrawal season winds to a close.

Since storage ratchets could force some excess gas into certain local markets, we would expect weakness in cash prices in these regions. However, ratchets should not have a large effect on forward prices.

Our forecast for end-of-March working gas in storage does not include the effects of storage ratchets. That is, we have assumed these do not affect the pattern of withdrawals. Storage ratchets have not affected the gas market in the recent past, as storage users have withdrawn enough gas throughout the previous winter seasons—it has been cold enough.

Current market conditions include a significant supply glut (U.S. supply is running 6.6 Bcf per day above year-ago levels) and storage overhang (714 Bcf and growing). This is heightening the concern that storage ratchets will cause the forced withdrawal of gas, resulting in a fire sale of distressed gas.

Exactly how storage ratchets affect the rolling of storage inventories from withdrawal to injection season is difficult to quantify. Nevertheless, before we draw any conclusions regarding price effects, it is best to understand how storage ratchets work.

Ratchets demystified

Storage ratchets are contractual obligations for shippers to draw down their storage volumes to a certain percentage of contracted levels by the end of the withdrawal season. Storage operators usually introduce these clauses to prepare for the injection season and protect the recovery of natural gas held in storage. When working gas is not properly cycled, there is the risk that gas will migrate from the storage field to surrounding geology and be lost.

Storage ratchets apply only to aquifers and the depleted oil or gas fields that need cycling during the year. Salt domes are not subject to storage ratchets, as these formations generally are not at risk of gas migration from the storage formation. Salt structures often allow gas to be cycled many times through a year. For a typical oil or gas field, operators manage the field with the goal of having the average pressure through the year at the pressure in the field when it was first discovered.

The formula is (PSI above discovery pressure multiplied by the days above discovery pressure) <= (PSI below discovery pressure multiplied by the number of days below discovery pressure). This equation varies by field, and operators have some flexibility, but this gives a general understanding of how they attempt to manage a depleted field.

Depleted oil or gas fields represent 80% of total U.S. working gas storage capacity. The management of the pressure within the cavern is important, as certain fields might experience degradation in the rate that gas can be injected or withdrawn if kept over- or under-pressured for a long time. Other storage operators, however, might choose to over-pressurize the cavern for longer periods to ensure the maximum flow rate during withdrawals.

With storage ratchets in mind, many wonder about the maximum amount of working gas that can be left in storage at the end of the withdrawal season. Using a combination of an EIA analysis done at the end of March 2008 (U.S. Storage Drawdown Analysis Report, April 1, 2008) and our estimates of working gas storage capacity additions since the time of that study, we estimate that the U.S. storage complex can exit winter with at least 2,400 Bcf of working gas in storage. This is above our estimate for end-of-March storage for this year, leading to our view that storage ratchets will not dictate end-of-March levels.

The expected end-of-withdrawal season storage level still has some way to go until hitting the estimated maximum allowable working-gas storage capacity. Source: EIA, Barclays Capital

EIA study

The EIA study reviewed the contracts of 61 storage service providers, 54% of the total in the country at the time (2008). This group owned as much as 89% of all the working gas storage capacity at the time of the study.

Key findings include that about 50% of the total working gas storage capacity was subject to some form of storage ratchets. The storage capacity that is tied to storage ratchets would need to draw down to 18% of total capacity by the end of the withdrawal season. This represents only 395 Bcf of available capacity by the end of the withdrawal season for fields subject to ratchets.

The EIA assumed that the 18% also applies to the companies with insufficient information, which represents 11% of the total working gas storage capacity in 2008. Also, about 38% of working gas storage capacity in 2008 was not subject to storage ratchets. As a result, the estimated maximum allowable working gas at the end of withdrawal season summed to 2,001 Bcf as of March 2008.

From 2009 to 2011, about 400 Bcf of working gas capacity added to the U.S. system was categorized as salt domes. Since these do not generally need storage ratchets, our estimates indicate that the maximum allowable working gas in storage could be at least 2,400 Bcf at the end of March. It is not hard to see that this is most likely an under-estimation, since clearly there are working gas capacity additions other than salt domes and not all of this new capacity will be subject to storage ratchets. Moreover, the EIA study applied the storage ratchets to the whole of the working gas capacity of each company, even though storage ratchets apply only to firm storage contract holders.

Barclays Capital survey

We have also surveyed several storage operators and found some features of storage ratchets that aid our understanding of their potential effects on the market. As noted above, a customer generally needs to draw down its storage to a certain percent of the contracted storage space. This ranged from 0% to 35% for the companies that the EIA studies. The penalties as a result of violating the storage ratchet provisions at the end of the withdrawal season vary, but generally fall into two types.

First, customers might pay a fee to roll their gas into the next month or injection season.

Second, customers' firm contracts could be converted to interruptible contracts. These customers might need to pay the company in kind. Usually the penalty is a small percentage, about 5% to 7%, of the gas left in storage that is above the storage ratchet limits, which is deducted from the customer's account. Some operators view this fee as a way to compensate for the gas that they believe would be lost from not cycling the storage field properly. Also, more often than not, storage field operators confiscate the amount of gas that is above the ratchet limit. This confiscated gas is typically withdrawn and sold into the market. About 10 of the 27 companies in the EIA study that have storage ratchets in their contracts penalize their customers via confiscation. With that said, in our conversations with storage operators, they expect customers generally to be disciplined enough to meet the storage ratchet provisions. Also, certain large storage operators that have many facilities would simply remove the amount of gas that is above the ratchet limit and move that physical gas to another complex. They charge only the fuel that is used to transport the gas from one field to another. This is deducted from the customer's account.

In a market where spare storage capacity is comparatively rare, it is more likely that an operator with spare capacity would charge a higher rate to take gas in a distressed market situation. There are also reports of possible forced withdrawals from storage fields that do not have ratchets if storage becomes too full this season. However, the amount of gas affected by this is not clear. Additionally, park and loan services, which might help some customers manage their excess volumes, might be affected when storage facilities become overly full.

Although it has been difficult to quantify how much gas could be withdrawn due to storage ratchets, we would expect that the users that face outright confiscation would tend to increase their gas withdrawal to meet storage provisions (some of which extend into April). They could either sell it into the market or send the gas to another storage facility.

Since we believe that over 70% of storage capacity is contracted to regulated entities, these customers would most likely simply sell the extra gas into the market. That is, regulated entities, which use storage for reliability and balancing needs, would not be expected to worry about how the sale of gas withdrawn from storage might further depress gas prices. Selling gas might be simpler than the complicated and costly process of sending gas to another facility. To a regulated company, storage is insurance. Selling surplus gas into the market simply means the insurance was not needed that year.

If users leave their beyond-ratchet gas in storage and wait for confiscation, operators would sell the gas into the market. In the case of either customers or operators selling gas into the market, storage ratchets would work to flush gas into the physical market, which would likely depress cash prices during the forced withdrawal period.

In the case of storage contracts that charge only a fuel cost or in-kind fuel penalty, the cost of leaving gas in a field might be too small to entice the withdrawal of the above-ratchet supply. If a storage user already has a multi-year storage contract and the fuel cost in the penalty is less than the time spread on the forward curve, it could benefit by choosing to absorb the penalty and roll their gas to the future. However, if rolling gas into the next month required a new annual contract, then a storage user might not be motivated to do so, as the seasonal time spreads (October-January spread) are quite weak at the moment and often do not cover the cost of storage for the full year.

If storage ratchets simply resulted in customers either rolling their gas into the coming injection season or moving it to another storage field, then the market would indeed start the injection season with a record level of inventory. This would tend to weigh on market concerns that inventory levels might trend toward over-capacity for October.

Note that it is not just the U.S. that sits with surplus inventory. Canadian storage is currently 183 Bcf, or 49%, above year-ago levels. Yet Canadian fields do not have storage ratchets in their contracts.

At press time, our projected end-of-March inventory level of 2,220 Bcf is below the peak end-of-March level that we estimate fields could accommodate for the U.S. Although there is likely some gas in fields subject to ratchets, our view is that storage gas subject to high penalties such as confiscation will be drawn from fields. This may cause short periods of very weak regional cash prices, but we doubt that storage ratchets will have a large effect on forward and even prompt month prices. n

Michael Zenker and Shiyang Wang are natural gas

analysts for Barclays Capital.

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