Investing Daily Article of the Week
by Igor Greenwald, Investingdaily.com
At a big energy industry conference in Houston earlier this month, an industry executive turned around in an elevator and addressed a reporter from Platts, the energy publisher.
“Today was crazy crowded,” he said. “And I thought this was Gas Day. I didn’t think people were interested any more. Guess it’s back.”
The reporter, blogging after the fact, wholeheartedly agreed, writing that the conference “was all about gas…because (it’s) so cheap.”
Yet, as the same reporter pointed out, no one at the same venue wanted to talk gas a year ago when it was being sold, often at a loss, at barely half the current futures price of $3.92 per million British thermal units (MMBtu).
So perhaps it’s not so much that natural gas is still cheap as the fact that its price has nearly doubled in less than a year from the crash levels brought about by the rapid increases in production. It’s also about the fact that natural gas would have to appreciate another 25 to 35 percent to reach its long-run historical average of $5 to $6 per MMBtu, and the fact that it could do sooner rather than later.
At first glance, this might seem like a pipe dream given the burgeoning discovery and production of natural gas from rock shale formations using advanced extraction technologies like hydraulic fracturing and horizontal drilling. Last year, US natural gas output increased 5 percent largely as a result of shale drilling, outpacing the 4 percent increase in gas consumption. That was on top of the 7 percent production increase in 2011.
But monthly totals reveal that much of the production gain took place in the early months of 2012, with the output leveling off thereafter. Why? Because low prices dramatically reduced drilling activity, but also because of a significant decline of output from the Haynesville Shale formation around the nexus of Louisiana, Arkansas and Texas. After flooding the market with progressively cheaper gas in 2010 and 2011, the Haynesville has seen monthly output decline by 14 percent between the peak in November 2011 and February 2013.
That’s only natural given the fast depletion rates of shale wells, though the widespread drilling of them is so recent and the geology so debatable, than the exact speed varies greatly with location and remains the subject of heated disputes.
For instance, Houston geologists Arthur Berman and Lynn Pittinger argue that the Haynesville is declining faster than anticipated, reserves remain overstated and that in general shale gas drilling is uneconomical over the lifespan of the wells at prices below $7 per MMBtu.
The US Energy Information Administration (EIA), on the other hand, foresees shale gas output increasing steadily for decades and trapping prices below $4 per MMBtu (in constant 2011 dollars) for the next five years.
But the EIA also knows that, alongside Haynesville’s decline, production from the Barnett Shale west of Dallas also began slipping slowly but steadily late last year after a decade of exploitation. That leaves the rapidly multiplying Marcellus Shale wells in Pennsylvania and West Virginia to pick up the slack and drive growth. By 2009, the Marcellus accounted for more than half of the undeveloped technically recoverable gas reserves in known US shale plays, according to the EIA.
Marcellus wells may decline less rapidly than those in the Haynesville or the Barnett but decline they will, and there is controversy over the extent to which the strong recent production in the known “sweet spots” of the Marcellus can be extrapolated to the rest of the formation.
So while the EIA’s long-range forecasts foresee a continued gas shale bounty, in the nearer term the agency expects no growth in overall US gas output this year or next, matched by similarly stagnant consumption.
I doubt gas supply, demand and prices can really mark time for so long: this market is subject to supply disruptions, economic booms and busts and the vagaries of trader psychology. In the meantime pipelines currently under construction will send growing volumes of US gas to Mexico, the capacity to export liquefied natural gas will have gone up and the modest use of natural gas as transportation fuel will keep increasing.
There are other shales out there that have been barely tapped, like the Utica in Ohio and the New York part of the Marcellus, the latter off limits to drillers for at least another two years. But the long-term capacity of these formations to meet US gas needs remains in question and almost certainly will require higher natural gas prices to be fully tested. Meanwhile, the EIA optimistically projects that 5 percent of US gas production will be exported by 2035. We’ll see.
In the near term, if the economy continues to improve, interest rates can be expected to rise and with them the cost of financing new shale wells and exploration. Berman and Pittinger estimate that the top 34 publicly traded gas producers face a capital spending bill of $22 billion per quarter to offset well declines, against aggregate quarterly cash flow of $12 billion in 2010. If their math is anywhere close to right, the price of natural gas will need to rise to cover the higher future borrowing costs.
So it’s possible, and maybe even necessary to be a bull on natural gas while staying sceptical about the shares of natural gas producers, especially those facing well productivity declines in mature formations. For some of them, the higher natural gas prices will have come too late. Whereas for many consumers of the fuel they might come much too early.
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