Natural Gas Is Going to 1997 Levels and is Going to Stay There for A While
Dispatch From the Marcellus: Natural Gas Prices and the Shale Paradox
In the middle of this decade, E&P companies were spurred on by rising commodity prices and easy credit to find and develop new sources of domestic natural gas–most notably shale gas. The forces that enabled this phenomenal growth in domestic gas production–the great asset and credit bubble–have vanished into air, into thin air. Now, Shale-gas companies may have been impaled on their own bayonets. Yet some would have us believe that natural gas prices are poised for a great comeback–that all the fret and worry is for nothing because prices are going to come right back up and justify the development of all the shale in the country, and then some. They are wrong: demand will continue to be weak and supply will not be nearly as sparse as the some of the gas-bulls would have us believe. Instead, the story of 2009, 2010, and beyond will be not only how much farther natural gas prices will fall, but also how long prices will stay in the basement, and who will be counted among the casualties.
The Fallacy of the Rig-Laydown, Production-Decline Pricing Idea:
U.S. producers, loudest among them being Chesapeake, are howling that lower prices will eventually lead to less production, which in turn will severely impact supplies and raise the price. But this is not a process which will lead to sustained greater prices, because even if this phenomenon caused a temporary or seasonal price increase, that would only encourage more production from known, vast shale supplies, and other prolific domestic sources like deep Bossier–which would result in another glut, and bring prices down again. In this scenario, wouldn’t the price just settle at a point which is only marginally better than the cost of production? Its also important to recognize that it takes less rigs actively drilling now to produce more gas than even a few years ago. With more built-for-purpose horizontal shale rigs active in places like the Marcellus shale, a few new, successful horizontal units can bring forth a level of production that may have taken 10 or 20 vertical wells to equal only a few years ago. For example, to date, CXG has drilled 5 horizontal wells with costs declining from $5.3mm for the first well to $3.8mm for the fifth well. The Company expects the next horizontal well to cost ~$3.6mm. Average IP-rate for the first 5 horizontal wells was 4.3 MMcf/d. If we assume the lower horizontal well cost of ~$3.8mm with a 3 Bcfe EUR on 40-acre spacing
Another factor which could cut short a price spike is that gas companies may have wells they have shut in and are not producing. They will turn these wells on as prices rise, allowing a rapid flood of natural gas to enter the market much faster than an increase in drilling could respond. It is also likely that if storage reaches capacity there will be no choice but to shut in some production. In any event, a slight rise in prices into the zone of marginal profitability would likely engender a race to bring on more production in order to realize cash-flow, which could flood the marketplace once again, causing the price settle at or near the break-even point. In this shale-supply driven scenario, prices will go to the marginal cost of production, so any industry gains in efficiency and cost-saving of production will only serve to drive the price down.
In the shale-supply driven scenario, big regional shale leaders like Range Resources could continue to make money producing high volumes at prices at or near the marginal cost of production, especially since Marcellus gas is usually sold at a nymex premium in the Northeast market due to savings on transportation. But this scenario does not factor in the burgeoning supply of natural gas headed to the U.S. on foreign-flagged tankers that can deliver as much gas in a month’s transport time as a good shale well can deliver over its entire productive life.
LNG and the Coming Wave of Cheap Foreign Gas:
Another product of the price bubble in recent years that has gone unnoticed by many Americans has been the massive new development in overseas gas fields. Unlike previous years, this development will affect the price of domestic gas because the increase in U.S. import/gasification facilities in the coming months and years means NG is becoming a global commodity. The last few years have seen a significant growth in the availability of liquefied natural gas (LNG) as both liquefaction facilities and available tanker numbers increase. The world’s LNG supply capacity is expected to grow 25% this year, and global demand will not match this increase. Therefore, LNG will be available to come into the American market. The United States tends to be the LNG market of last resort, as producers send LNG to the higher paying Asian and European markets first. However, global LNG demand and prices have fallen, leaving more LNG for the United States, whose extensive storage and pipeline network means it can absorb LNG even at times of low demand. “It’s completely counterintuitive,” said Murray Douglas, a global LNG analyst with Wood Mackenzie in Houston, who is predicting U.S. LNG imports will grow 30 percent to 456 billion cubic feet this year and to more than 1.1 trillion cubic feet by 2013. “We don’t believe Asia and Europe will be in a position to absorb this new production, and the U.S. is the only market that can take it, that has a large amount of storage.”
LNG can be competitive priced as low as $3 per million British thermal units (and perhaps lower), said Zach Allen, head of Pan EurAsian Enterprises, a management advisory firm that follows LNG markets. That’s a price the U.S. hasn’t seen since 2002. “Some cash is better than none, especially for producers who rely heavily on that cash for social and other programs that would be politically explosive to cut off or cut back,” Allen said. The biggest contributors to the world LNG market is Qatar, followed closely by Indonesia. The productive capacity of the gas wells in these countries dwarf domestic production, and new liquefication-export facilities that have activated in recent years, and more that will be coming-on-line in the coming months, will only add to the world’s ability to produce LNG. What’s more, most of these big, foreign wells have zero or near-zero cost of gas production, because they produce liquids in volumes sufficient to pay for the cost of finding and developing the wells. So they are essentially producing gas for free.
Even more encouraging for foreign LNG producers is the discovery of new super-giant, and world-class giant gas production zones. Overshadowing them all, is InterOil’s recent new discovery in New Guinea, the Antelope 1 well, which likely contains Ten Trillion Cubic Feet. One well, ten TCF. Just put a liquification plant near-by and that well could supply the gas needs of several countries for many years.
Even without any of the additional supply from these new fields, the new production coming on line in Qatar is more than the current market can absorb, and the Qatar CEO notes , “For the shorter term, I don’t think the UK will be able to take 16 million tons,” al-Suwaidi said. “Anything the UK cannot absorb, we will have to find a market for.” The consumption of petroleum products in Japan, the world’s biggest buyer of LNG, is projected to fall 4.7 per cent in the year starting this month, according to the Institute of Energy Economics Japan. The global recession has reduced electricity use in Japan. Barclays Capital said the global LNG market will add 5.6 BCF/d of production capacity to the 23 BCF/d currently online. (Barclay’s Latest view on the LNG-supply to world demand quandry)
Current U.S. LNG gasification-import capacity is about 60 million tons per year, and several new LNG receiving terminals are coming into operation in 2009, including Sabine Pass in Louisiana. (One metric ton is equivalent to about 48,700 cubic feet of NG). One LNG tanker can transport 6 billion cubic feet of gas–which is equivalent to estimated recovery over the lifetime of a decent shale well. While the EIA estimates LNG imports to average about 369 BCF, estimates vary widely. “We are going to be awash in natural gas and could have $2 gas”, says Steve Johnson, president of Houston-based Waterborne Energy Inc., which tracks LNG shipments. He also predicts that the US will see 1.1 TCF of gas delivered to the US in 2009 as repairs to some LNG export facilities overseas are completed, new projects come online and seasonal shifts in global demand increase the amount of LNG in the market.
LNG: there’s plenty of it, just like there’s plenty of Shale. The difference is that no matter how cheap it gets to produce Shale gas, LNG will always be cheaper–it costs nothing to produce so the only cost is transport. And that transport cost is only between $1.29 to $2.09 from the Middle East to various U.S. import facilities. Its doubtful that Shale producers could be profitable at those levels. With so much cheap LNG in the world, gas prices in the coming years may not be based on futures at all, Henry Hub could be a thing of the past, and U.S. traders might just be buying and selling gas based on spot LNG prices.
Demand Side:
“Demand destruction will still outpace supply destruction through this summer and into next winter, “Stephen Schork, president of the Schork Group Inc., an energy markets consulting company in Villanova, Pennsylvania, said in a note on April 24th. Businesses are closing, and unemployment continues to rise, which means big trouble for natural gas prices.
NG is a major power source for electrical utilities, and it has been building up in storage at levels well above seasonal averages as manufacturers cut back on production. The EIA reported Thursday that natural gas in U.S. storage is now 36 percent greater than it was at this time last year. On Friday, American Electric Power said that electricity use by industrial customers in its region fell 15 percent. That falling demand can also be seen clearly in recent unemployment figures, with energy intense industries like manufacturing hit particularly hard. Earlier this year, Dow Chemical, which had previously been one of the largest single consumers of NG in the country, closed 20 plants and cut 5000 jobs since December. The three major U.S. automakers have slowed down production this year to match a plunge in demand. General Motors said Thursday it would shutter 13 assembly plants for up to 11 weeks this summer. Ford Motor Co. also has cut back on manufacturing this year.
In addressing the demand for natural gas this year and in the coming years, we must acknowledge that demand for natural gas is a reflection of aggregate demand in the greater American economy, and therefore the global economy. Because manufacturing and fertilizers make up such a large portion of the demand picture for NG, it is unlikely that such demand will increase to levels seen in recent years as long as the overall economy remains on its current deflation-depression path.
So, deflationary forces retrench across the world economy, even in the face of unprecedented low interest rates and quantitative easing by central 
banks, and demand for NG stays weak. Where has growth come from, anyway, in the last ten years?–other than by an expansion of the money-supply and credit? The fate of NG prices is just a manifestation of the credit-bubble blow-back. A look at almost all other asset classes shows them returning to 1997-1998 levels, adjusted for inflation. The S&P 500, at present writing, is at about 1998 levels, and real estate, though widely varied across the country, is at about 2002 levels and continues to fall as new-buyers shy away and inventories of unsold houses stagnate. If the most of the economic growth in the last ten years as been a product of the great asset and credit bubble, and all asset classes are deflating down to values last seen ten years ago, then why shouldn’t NG prices go back to 1997-1998 levels?
As we mentioned above, the cost of getting the LNG from its foreign origin to other markets is low. The 43-day round trip from the huge export terminal in Qatar to the Lake Charles LNG terminal costs $2.09 per million British thermal units. From Egypt to Lake Charles takes 30 days and $1.29 per million Btu. $1.29 to $2.09? Funny, that’s precisely where gas prices were in 1997, 1998. The grip of deflation is firmly in place. Go down, Moses, and take NG prices with you. So, prices will revert to the mean and crash through it, right back to the late ’90s levels–which is where prices should be (after all) at a more honest time (perhaps), before the bubble took hold.
If we are going back to 1998 levels, then it looks like we can take several TCF off the table, which suggests that only the largest, most prolific, and most efficient domestic gas plays will be workable.
Without the dawning of a new source of domestic demand for NG, domestic marginal producers can fuggedaboutit. LNG will punish them. Still, the prospect of low nat gas prices persisting well into future makes NG attractive as a fuel for electricity generation and transportation. I don’t know, but anyone in the power world out there please chime in, if you are operating a power plant at dual capability, at what point do you switch to NG from Coal? $2.50? Please chime in and comment here, Coal people. That may give a glimmer of hope to those in the NG business. But no hope can be found in the Obama administration, which scorns all associated with the O&G business, so its not likely that NG will get much support from government “stimulus” efforts of from Dept of Energy policy. Even if we were to actually see a proliferation of new usage of gas as the product of government mandates or incentives, any marked increase in the actual amount of gas consumed from those hypothetical projects would still be years off. And its doubtful that many domestic producers can weather such a long stretch of very low prices.
AY, great insight and interesting to see resource breakevens from haynesville and some of the cotton valley sands guys. I wonder how much of US production is hedged in 09 and 2010 at much higher prices than the strip? The coal substitution is a great question and I look forward to some insight from anyone in the utility area. Finally, Obama is natural resources #1 enemy. While he and the leadership speak about energy independence, they really could care less about domestic E&P companies and have no problem importing energy from abroad and focusing on alternative energy. I am not sure how much the markets really understand how little the administration cares for them. Could we ever see price floor subsidies for energy companies all in the name of jobs jobs jobs? Can you imagine an energy bailout bill?
this is really the first comprehensive piece on the web (that i have read) to take this position. great stuff. this is contrarianism in all its glory. the nat gas strip is going to get annhilated…12 mos out its still pricing in $6 gas, which is pure hogwash. Just to add to the demand argument (with reference to the credit bubble), there is no possible way demand will return to 2006 levels, not at least for several decades. The credit bubble was fueled by East Asia’s recyclement of the record US trade deficit. This massive trade imbalance growth is slowly grinding (and i mean grinding!) to halt. It then must reverse itself…with asia becoming net consumers and the west becoming net producers. All of that takes a paradigm shift in demographics as well as infrastructure…in other words, that doesn’t just happen overnight. Also, to invoke schork again, he made the great point that GM is furloughing 13 assembley plants for 3 months (at least) and that will have devastating effects on nat gas demand…here’s the ap article: http://news.yahoo.com/s/ap/20090423/ap_on_re_us/us_gm_factories.
keep up the good work!
Anon, thanks. I couldn’t agree more. NG prices are a reflection of aggregate demand in North America–which is anemic and weak, and looking bad. The only hope for prices is inflation. please spread the word about this blog if you deem it worthy.
How can you take a long-term view of U.S. NG without mentioning production from conventional reservoirs, or from tight sands in the Rockies? What portion of current U.S. production comes from non-shale sources? Perhaps it is a meaningful oversight to ignore such a large component of the production base.
What are the impacts of hedging gains on development budgets of firms like Range Resources? Aren’t they selling close to 80% of 2009 gas at around $8? Haven’t we not seen $3-$4 NG flow through to development budgets?
You are far from presenting the complete picture. Best wishes.
DB. RRC hedged about 70% at about $7.50 through 2009. They are not hedged as of the 4Q 2008 call in 2010. Many other independents are, though. But any company that has to rely on hedges to survive will not be in good shape. Who will be on the other side of those hedges when prices are at or below the marginal cost of production. Tights sands are like shale in respect to their cost, and the price of gas in the Rockies is lower than Marcellus gas (even though that Ohio pipeline may have something to say about it), but 1., the analysis is the same that it will not be economical absent hedges (and you can’t hedge forever in a period of sustained low prices) and 2. the level of production from those formations are lower than the big, new horizontal shale units that have been proven across the South and East in the last 12 months.
You are correct that a lot of gas comes from conventional wells, many in the Gulf area–like McMoran’s huge Tiger Shoals discoveries in-shore Vermilion Parish, which is profitable at levels well below Shale, Rocky Mountain Tight Sands, and almost all other sources of domestic production, and it will probably never be shut-in, therefore their operation do not weaken my thesis that supplies are not going to dissipate relative to the annihilation of demand that we are seeing, and that prices are going to stay low.
Thanks for commenting and please share the site if you deem it worthy.
When you consider conventional production, it is one thing to mention highly profitable, high flow rate discoveries. But, you shouldn’t look at these discoveries in isolation…you have to consider the low success rate for new discoveries and what exploratory dry holes do to the economics of conventional production. For each Tiger Shoal, Flatrock, or MCF’s Dutch/Mary Rose, there are plenty of dry holes that get us to break-even economics closer to $7.
I think your view of sustained low prices ignores the majority of gas production - conventional reservoirs, and the overall economics surrounding these projects. How do we have a balanced gas market when the source of the majority of US production is uneconomic? How do you not even mention the majority source of gas production in your post? You’re not providing a comprehensive analysis.
If the Rockies tight sands production is so low cost, and economic at today’s price (well, we do not yet have a representative picture of the economics at today’s prices because these companies are being supported by hedging gains) then why has Ultra Petroleum dropped their rig count in the Pinedale, perhaps the most attractive field in the lower 48?
DB–I get your point, well put and accepted. However, given the growing supply of LNG, and the growing capacity of import facilities, wouldn’t the decline in US conventional production make LNG more attractive, given that its low cost and can easily be delivered to fill up storage more quickly than domestic production can be ramped-up? Again, I appreciate the discussion.
AGY,
There is a difference between theoretical LNG import capacity, and actual LNG imports. Just ask Cheniere Energy…a painful example.
If gas stays at $4 for many years, the hole created in conventional production cannot be filled with a couple Bcf/d of LNG, or by shale gas. Shale gas growth, when limited to actual cash flows generated at $4 NG, will disappoint. Hold Nymex at $4, and you lose the entire Piceance Basin, the Uintah Basin, growth from the Pinedale, growth from the Barnett. This price keeps the Woodford Shale sub-economic. You also remove the incentive to produce from virtually everywhere except from the Marcellus, and the Haynesville.
LNG imports are down in 2008 and 2009 relative to 2007. We have been hearing of the flood of LNG to the U.S. for many years, and now we have under-utilized import terminals, and construction of LNG export facilities in British Columbia (Kitimat LNG: http://www.kitimatlng.com/code/navigate.asp?Id=2). Not exactly a bull market in LNG imports, but then again, the story remains seductive.
U.S. is the LNG dumping ground of last resort. Netbacks virtually everywhere else around the world are higher, thus the poor utilization. Low prices here will keep away LNG.
DB: “your view of sustained low prices ignores the majority of gas production - conventional reservoirs, and the overall economics surrounding these projects”
DB i think this view ignores the impact of falling oil service co margins over the next year and a half. a lot of stuff is uneconomical today, simply because costs have not fallen as fast as prices. listen to SLB, NOV, etc. conference calls and their margins in NA are getting hammered…since 2000, operating margins tripled and quadrupled for service names. Given the falloff in rig demand, these companies are losing pricing power writ large and its only a matter of time before costs come down to levels similar to prices. so all this talk of $7 nat gas and $75 oil is out-dated and stuck in a behavioral anchor that desperately “wants” to believe energy is not just another, overly abundant commodity.
anon,
I think you may be the one burdened by a behavioral anchor, as you call it. The history of gas in the $2’s far exceeds the history of gas at or above $7…talk about a multi-decade behavioral anchor!
The reality of conventional production is declining prospectivity with time. Just take a look at activity in the GOM shelf. The same phenomenon exists throughout conventional-production-land…deeper targets, smaller per-well recoveries, infill/rate acceleration drilling, and the like. Not so with shale gas, but this does not yet dominate supply as the article would like for us to believe. Conventional production still plays a dominant role, and needs higher prices.
In your view, then, I suppose the rig count will begin to rise furiously as service costs decline? Haven’t rates not subject to longer term contracts already fallen meaningfully? Oh, right, I guess it’ll be any day now that margins will permit for conventional drilling at $3 NG. We’ll just have to wait for the big rig rebound that you expect any week now!
Good luck.
I disagree. But the article has been very useful to me, thanks.
In general, commodity prices don’t gravitate to equilibriums, they tend to overshoot in both directions. As they do, production overshoots too. This is because there is a fundamental prisoner’s dilemma style game at play. When prices are high, everyone wants the other guy to cut production to support prices, but for themselves they want to capitalize on the profits. So as a group, they all overproduce and create the crash. When prices are low, producers don’t want to produce just enough, they want to cut back as much as possible to either save gas for better prices or stop the hemorraging. In this case they don’t care if everyone else does the same, they even support each other, because that brings the price back up.
Also, LNG is not as dirt cheap as you make it sound. It has costs to compress/transport/expand. To compress, a lot of impurities have to be filtered out to make damn near 100% methane, or you get problems. Then it has to be shipped overseas, adding the price you quote. And it is not free at wellhead, the fact that gas pays off the well simply says the well is economic, as is true of most wells. And the US doesn’t have to take the gas, the supply from Qatar, Malasia, and Indonesia can be throttled back. Don’t confuse potential production with estimated production or actual production. Actual will be lower in your scenerio.
Energy demand in total may fall due to this economy. I expect a long devastating depression, potentially worse than the “great” one… yet, as others have pointed out, NG could still rise as a percentage of energy used as coal becomes too expensive due to regulations. NG is cleaner and puts out half as much CO2 as coal. Geothermal and wind might be cheaper than coal too, but are only available in very specific “lucky” areas.
Mike, thanks for the comment. RE costs to compress/transport/expand, that does not compute in the LNG producers cost so it will not discourage them from shipping here. RE “that gas pays off the well simply says the well is economic, as is true of most wells,” are you talking about liquids? That’s what I was talking about (perhaps poorly). Your point re actual and potential production is well taken, and I aver that the cheaper the potential production is, the more it will push out more expensive domestic production. Thanks again for reading, your thought are appreciated.
Interesting and thorough analysis. As someone who works in the power industry, I can tell you that there aren’t many power plants that can switch between coal and NG. However, plenty of utilities and many merchant generators have NG fired plants. If the NG price falls below the price of coal, look for the power plants to maintain demand at just under that break-even point.
Two major wildcards that don’t seem to be addressed in this post:
1) Carbon tax or Carbon Cap-n-Trade. Depending upon if, and how, this is passed, look for the US government to tax the cost of using fossil fuels. Coal will certainly have a higher carbon tax than NG. How much? It’s hard to predict. However, almost overnight, this could make the NG more economical than coal for power producers. Generally, the gas plants sit idle and generate power during peak power consumption periods. That idle capacity can be started at any time.
2) T. Boone Pickens efforts via the Pickens Plan. While most people think of Pickens efforts around wind, he is also a big proponent of using NG as a fuel for vehicles (most major trucks). As Pickens suggests, we don’t have the technology to make a battery-powered 18-wheeler. Again, to make this have an material effect anytime soon, the government will have to intervene, but Pickens has deep pockets and a large group of supporters, so don’t count it out. Pickens option becomes even more attractive as NG prices become lower. Obama is set on energy independence and I think Pickens Plan represents the best way to wean the US off the use of oil (which also happens to burn dirtier).
I enjoyed your piece, thanks for pointing it out. Can you expand upon why shut-ins would raise the price to just above the marginal cost of production? I could see that being the case if setup was easy, but I don’t think it’s that simple just to drill a little more when prices start to move up. Supply tends to lag price quite a bit in this market.
Thanks for good post
Terrific web site:D Hope to visit once again:D
Interesting stuff and your warning against looking purely at the rig count as a means to pick a bottom in nat gas prices is a valid one. However, your analysis of demand (or lack of) seems to focus on the US to exception the rest of the world. Yes, as the world’s biggest energy consumer, the US does exert a huge influence on the global demand-supply picture. But aren’t you forgetting a little country called China, which will be the main driver of global economic in the 20 years and has a string of LNG storage facilities coming on stream along its east coast from 2010 onwards.
“The fate of NG prices is just a manifestation of the credit-bubble blow-back. A look at almost all other asset classes shows them returning to 1997-1998 levels, adjusted for inflation. The S&P 500, at present writing, is at about 1998 levels, and real estate, though widely varied across the country, is at about 2002 levels…”
Rather than comparing nat gas with stocks and property, would it not be more valid to compare it with other commodities. Tell me, what was the price of gold in 1998, or wheat or steel or dare I say even oil. Commodity and stock prices are inversely correlated, so to suggest nat gas prices should fall because stocks have also is misleading. The longest bull market in commodities began in the middle of the Great Depression in the 1930s. And we all know how the stock market looked back then….
Anon:
Relying on correlation is charlatanism–or have you forgot the wreckage wrought by reliance on the Gaussian copula function in correlating risk of default when packaging CDO’s? The fundamentals are much different between now and the 1930s. For one thing, the market for NG was tiny then, and most of it was just flared off. There is a mini-bubble building in commodities and it will burst.
David Rosenberg yesterday: “The key issue is the differential between absolute and relative price increases: in many ways the current inflation scare is even less moot than the panic in the summer of last year, when it became painfully obvious that neither retailers nor final-state manufacturers have pricing power (think excess capacity: if the manufacturing ISM is any indication, this pricing power is only going to get further obliterated in the coming months, eating away directly at the bottom line, and making the forward EPS ramp up even more of a mirage in the manufacturing sector; also worth pointing out that non-manufacturing ISM actually fell by 2.6% to 44.4%).