Wednesday, April 13, 2011
Parks Paton Hoepfl & Brown
by G. Allen Brooks
"In terms of new sources of energy, we have a few different options. The first is natural gas." These were the words of President Obama in his remarks entitled A Secure Energy Future, delivered on March 30th at Georgetown University. For being the first of various energy fuel options, however, natural gas received precious little additional mention during the President's comments other than his view that "recent innovations" have given the United States "the opportunity to tap large reserves – perhaps a century's worth." Even the leader of the country has bought into the mystique of the super abundance of natural gas from shale that appears to be ubiquitous throughout North America.
The President cautioned his listeners, though, that the government needs to make sure that the oil and gas industry is tapping these shale reserves "without polluting our water supply," a bone thrown in the direction of environmentalists who seem to be losing in their efforts to restrict the burning of fossil fuels. In his comments, President Obama said he was asking Secretary of Energy Steven Chu to work with other federal agencies, various state governments, environmental specialists and the natural gas industry to "improve the safety of this process [hydraulic fracturing of gas shale formations]." President Obama made a point of mentioning that Secretary Chu has a Nobel Prize for physics. According to the President, "He likes to tinker on this stuff in his garage on the weekend." We're not sure whether that comment was to compare Secretary Chu to Bill Hewlett and David Packer who created a technology and commercial powerhouse company or to Christopher Lloyd who played Dr. Emmett "Doc" Brown in the 1985 film, Back to the Future. We must say we haven't met many physicists tinkering in the domestic oil and gas industry.
There appears to be a sort of Dr. Jekyll and Mr. Hyde outlook for natural gas. Recognized as a lower carbon, i.e., cleaner, alternative fuel choice that possesses significant energy and provides consumption flexibility to meet the multiple energy demands of modern society, natural gas should be in high demand. That demand should be further boosted by its current low price – the product of significant new supplies of gas and declines in energy markets needing it. The problem is that the financial crisis of 2008 has produced one of the most anemic economic recoveries since the Great Depression. The economic downturn and weak recovery has reduced energy demand. This, coupled with government mandates for increased use of renewable fuels in the utility sector, has created increased fuel-on-fuel price competition, in particular for coal and natural gas. But the real culprit has been the growth in supplies of new natural gas.
Exhibit 1. Oil Prices Boosted By Geopolitical Problems
Source: EIA, PPHB
At the same time gas prices were collapsing, explosive oil demand in the developing economies of the world, principally in Asia/Pacific, combined with geopolitical turmoil have driven oil prices significantly higher than where they would likely be absent the civil unrest in the Middle East and North Africa. As it appears, the political problems in Libya, and now Syria and Yemen, are not improving quickly and, in fact, could actually spread to additional Middle Eastern countries. The upward pressure on global oil prices is likely to increase in the near-term.
The price divergence between crude oil and natural gas has produced a profoundly distorted relative valuation of these fuels. The energy content of natural gas to crude oil is 5.6 to 1.0, or six to one for ease of figuring. The current West Texas Intermediate (WTI)
Exhibit 2. Oil Trading At 25-times Gas Value
Source: EIA, PPHB
crude oil price of about $112 per barrel suggests that a thousand cubic feet (Mcf) of natural gas should be valued at roughly $20. Instead, the ratio of the price of crude oil to natural gas has expanded to about 25-times. As can be seen in the chart in Exhibit 2, between 2005 and 2008, this ratio averaged around 10-times. Since the beginning of 2009, the ratio has increased to an average of about 20-times. Given the run-up in crude oil prices and the prospect of only modest increases in natural gas demand, the oil to gas ratio is now moving closer to an average of 25-times. At some point the ratio will reverse. The question is what will have to happen before that trend reverses?
Most natural gas industry observers have focused on two trends in trying to understand market sentiment – the gas-directed rig count and the monthly gas production figures. The gas rig count is reported weekly by several sources and is being sliced and diced regularly by analysts trying to discern early movements in activity that may foreshadow declines in gas production, which presumably would lead to higher natural gas prices in the future. The problem is trying to ascertain how long in the future before gas prices might rise.
The problem in answering the timing question is that natural gas production totals are reported monthly and then with at least a one month lag. The latest natural gas production figure for January (derived from the federal government's survey on Form 914) showed only a very marginal decline from the prior month's revised production estimate. On the chart in Exhibit 3, the latest decline looks somewhat larger because we plotted the initial production estimates as that is all we have from the January report.
Exhibit 3. Gas Production Growth Slowing
Source: EIA, PPHB
We focus on the Lower 48 states' gas production data as Alaska's production, while important on a national basis, has little impact on the dynamics of natural gas prices. We do look at the trend in Gulf of Mexico natural gas production, which has shown a steady downtrend since 2005 and is not apt to change especially given the disruption to offshore drilling due to the BP oil spill.
Exhibit 4. GOM Production On Down Trend
Source: EIA, PPHB
When one removes the Gulf of Mexico from the Lower 48 gas production figures, what is left is natural gas production from land sources. While the chart visual shows a flattening of land production, there are questions about how much production might have been restricted to prevent producers selling gas into a weak pricing environment given the high levels of natural gas in storage.
The real challenge for the natural gas industry is to understand how much drilling activity is being driven by the need to start production in order to hold lease acreage recently acquired by producers and is boosting production at a time when natural gas prices are weak. The implication is that producers would like to exercise capital
Exhibit 5. Land Gas Production Flat
Source: EIA, PPHB
deployment discipline but that their activity is forced by the need to drill to hold acreage. If we could sense when this drilling driver stops then we might be able to speculate on how quickly natural gas prices might rise.
Exhibit 6. Oil Drilling On The Rise
Source: Baker Hughes, PPHB
We can see that over the past 25 years, there was a significant shift in domestic drilling focus from looking for crude oil to searching for natural gas. In 2005, the decline in oil drilling ended. That coincided with the start of the climb in crude oil prices that peaked at the time of the financial crisis in 2008. The rise in oil drilling stopped in late 2008 but began recovering in the summer of 2009 as prices rose. At that point, restrictions on capital availability for the oil and gas industry had eased, the crude oil market strengthened, and crude oil prices rose.At the same time, natural gas prices were flirting with the $3 per Mcf level making many of the gas shale plays that had been driving gas-oriented drilling uneconomical. Since then, continued weak natural gas prices coupled with stronger than anticipated oil prices have driven the relative disparity in drilling activity in each market.
As a result of the shift within the gas shale plays to those with higher liquid content – more oily – the domestic rig count has accelerated its shift toward oil-focused drilling to the point that the rig count is about evenly split between rigs seeking oil and those after natural gas.
Exhibit 7. Gas And Oil Rigs About Even
Source: Baker Hughes, PPHB
This shift in the rig count is giving some gas industry players a reason to be optimistic that gas market price signals have sent the proper message to producers who are cutting back their gas-oriented drilling. The hope is that the weak gas pricing environment may end sooner than previously expected as a result of the shift in drilling. These optimists point to the shape of the curve in natural gas futures prices.
The futures curve reflects a steady upward trend in natural gas prices that reaches price levels by the end of 2014 that have not been experienced since January 2010. If one excludes the higher winter month prices, then the prospect is that 2014 will show about 50% higher prices compared to averages for 2009-2010.
Exhibit 8. Gas Futures Signal Improving Market
Source: EIA, CME, PPHB
The hope behind the gas industry's growing optimism is that the shift in drilling by horizontal rigs toward more seeking oil will lead to a decline in production from gas shale wells. When the total number of rigs drilling horizontal wells is compared to Lower 48 gas production, one can see the recent slowdown in gas production growth, which mirrors the slowdown in the growth of the number of active horizontal drilling rigs.
Exhibit 9. Rig Count Suggests Slower Gas Supply Growth
Source: EIA, Baker Hughes, PPHB
What we do know about the growth in the number of rigs drilling horizontal wells is that many more of them today are seeking crude oil and/or liquids-rich shale plays. To try to gain additional insight into the current relationship between the drilling of horizontal wells and gas production, we applied the percentage of rigs drilling for natural gas to the number of rigs reported as drilling horizontal wells. This is a short-cut as the more accurate way would be to check the location (basin) in which each rig is working and what the likely target of the well is in order to determine exactly how many horizontal wells are drilling for gas as opposed to oil.
Exhibit 10. Gas-oriented Rigs Not Slowing Supply Growth
Source: EIA, Baker Hughes, PPHB
Our short-cut analysis resulted in the data plotted in the chart in Exhibit 10. What it shows is that the estimated count of rigs drilling horizontal wells targeting natural gas peaked in September 2010. On the other hand, natural gas production has continued to climb. There are various reasons why this may be the case. For example, the population of drilled but uncompleted wells in many of the gas shale basins due to a lack of equipment to perform hydraulic fracturing on the wells has grown. So while fewer gas wells are being drilled, the number of completed wells is higher resulting in more gas production than would otherwise be the case given the reduced number of active drilling rigs.
Exhibit 11. Uncompleted Wells Spell More Gas Supply
Source: Raymond James
Another explanation is that there is a fair amount of associated natural gas produced from the liquids-rich shale plays that have exploded in industry importance over the past 18 months due to the price disparity for liquids versus gas. The high-profile shift in drilling focus to liquids may not be diminishing the amount of natural gas production envisioned when one focuses only on the shift in basin activity. When one looks at the chart in Exhibit 12, if becomes clear that Marcellus, Woodford, Eagle Ford and Granite Wash wells produce substantial volumes of natural gas in their first year of production, albeit less than a Haynesville well, but much more than the average production from a conventional vertical well. It is estimated that horizontal wells contain three times the estimated ultimate recovery of a vertical well. At the same time, horizontal wells usually have four to five times the initial production of vertical wells, making them a powerful factor in growing production.
Another consideration for growing gas production despite a drop in gas-focused drilling rigs is the dramatically improved efficiency in drilling and completing the latest batch of horizontal wells. Various oil and gas producing companies have reported on their ability to
Exhibit 12. Oily Basins Supply Substantial Natural Gas
Source: Raymond James
apply technology, equipment and knowledge to reduce the number of days required to drill wells in many of the early gas shale and tight gas sand formations. That means more gas per well and fewer rigs needed.
Exhibit 13. Drilling Efficiency Adds To Gas Supply
Source: Raymond James
One estimate we have seen suggests a producer can drill two Eagle Ford or two Marcellus wells in the same time required to drill one Haynesville well. As a result, the gas production from those two Eagle Ford wells will equal the volume from the one Haynesville well. The gas production from the two Marcellus wells will not equal the output from the Haynesville well, but it will be close.
When we finish looking at all the data we are left with the feeling that the natural gas market is on the road to recovery. The very bullish gas price outlook that existed merely two years ago is long gone. That said, however, one cannot underestimate the power of gas demand to boost gas prices, and if that demand comes at a time when the industry has cut back its drilling due to the poor economics of gas shale plays, we could see sharply higher gas prices in a fairly short time. We still believe the odds favor a long, slow road to higher natural gas prices. The gas futures curve may have it about right this time.
G. Allen Brooks works as the Managing Director at Parks Paton Hoepfl & Brown. Reprinted with permission of PPH & B.
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