Will Natural Gas Price Bears Be Disappointed This Year?

An article in the business section of the Ft Worth Star-Telegram over the New Year's weekend discussed the outlook for the region's natural gas play – the Barnett Shale – in light of gas prices closing out 2011 at under $3 per thousand cubic feet (Mcf). The expectation is that this low gas price will continue in 2012 and act as a damper on activity in the basin. A senior energy analyst with the investment firm Global Hunter said that the impact of weak gas prices can be expected to cause drilling to "tail off in the Barnett….It's going to be hard for them to keep the rigs running." Global Hunter has reduced its projection for 2012 average gas prices to $4/Mcf from its prior $5/Mcf estimate. In light of currently weak gas prices, the firm expects to further reduce its price projection.

Earlier in December, the Energy Information Administration (EIA) lowered its estimate for average natural gas prices this year to $3.70, down from its prior projection of $4.13. The agency attributes the fall in prices to the sustained production growth from gas shale basins that has pushed total U.S. natural gas production steadily higher. The EIA estimates that 2011 production averaged 65.9 billion cubic feet per day (Bcf/d), a 6.6 percent gain over the average for 2010. Since gas production grew throughout the year, coupled with few signs of any slowing in gas drilling activity, which absent a dramatic demand increase will contributes to further production growth, there will continue to be a gas surplus depressing prices.

One of the impacts of the fall-off in drilling in the Barnett has been a decline in the financial terms for new leases. An executive of a company involved in negotiating leases in the basin pointed out that in 2008, at the height of the Barnett boom, landowners could lease their property for $25,000-$30,000 per acre and 25-27.5 percent royalties. Today, typical lease terms would be $2,500-$3,000 per acre (some deals can get as high as $5,000-$7,000 an acre) with 20-25 percent royalties. The days of super-wealth from land ownership may be over. As one landman once described things at the height of the boom, he laughed as he drove past a gas station and saw a farmer in his overalls filling up a Maserati.

The extent of the decline in drilling in the Barnett can be seen from the chart (Exhibit 1) showing rig activity of major producers operating in the basin since 2008. At year-end, Barnett active rig count jumped up to 64, but it is still only about a third of its 2008 peak.

Exhibit 1. Barnett Producer Rig Count Down Sharply

The drilling decline can be directly tied to the fall in natural gas prices over this period. At the height of 2008, natural gas futures were priced in excess of $13/Mcf. Today, at just under $3/Mcf, natural gas prices are less than a quarter of their peak in 2008. During this same period, while leasing terms declined, most oilfield service costs increased making it highly unlikely producers were making money from drilling purely dry gas wells. To the extent that gas prices remain where they are currently trading, it is hard to see how there will be any incentive for producers to boost their drilling activity. But in the end, this is the natural course of events that will take us to higher commodity prices as the cessation of drilling activity results in a decline in gas production, reducing the supply overhang that is depressing gas prices.

One can already see the impact of the reduction in drilling since 2008 in the chart in Exhibit 3 showing Barnett Shale horizontal well production since 2003. Gas production from horizontal wells increased steadily from 2003 until reaching a peak at mid-year 2009. Production then declined for about six months before resuming a steadily increasing trend until recently. As the data shows, the

Exhibit 2. Gas Is Now A Quarter Of 2008 Price

number of producing horizontal wells increased 230 percent between January 2008 and the fall of 2011, but gas production during that period only increased 62 percent. This looks like a clear case of declining well productivity from newly drilled wells. New production is struggling to offset the depletion from existing producing wells.

Exhibit 3. Wells Growing Faster Than Production

What we are seeing in the Barnett data is the "treadmill effect" of gas shale developments. That means that if drilling doesn't remain high, a basin's total output will eventually stop growing, flatten out and then start to decline. The timing of this sequence will be determined by the relationship of the productivity of new wells compared to older producing wells since the normal pattern in exploitation of a basin's resources has the more productive wells being drilled initially with subsequent wells being less productive. As a result of this pattern, the number of new wells drilled needs to increase faster to offset the declining output from earlier, more productive wells.

We may be about to experience Barnett production trends nationally. The EIA gas production data obtained from the Form 914 survey for October showed that onshore output grew at half the rate of September. Between October and September, Lower 48 Onshore gas production increased 0.54 Bcf/d. This was in contrast to the September/August increase of 1.37 Bcf/d. This much smaller October increase came despite the Baker Hughes gas rig count increasing by 26 rigs, which was twice the increase experienced in September. The rig count data for November and December showed gas rig declines of 53 and 49, respectively, leading us to think we may see a further flattening in gas supply growth.

The interesting thing about the individual state production data is how trends are beginning to show that gas production may be slowing. In October, the Lower 48 producing states other than Louisiana, New Mexico, Oklahoma, Texas and Wyoming accounted for two-thirds of the nation's production increase. Those same "Other States" were responsible for only 15 percent of the total increase in September. Additionally, Louisiana and New Mexico production was down in October after being up in September. The other large producing states were also showing significant slowing of production growth. Oklahoma was only up 0.01 Bcf/d in October versus 0.07 in September. Texas experienced half the rate of increase in October from September while Wyoming had about a third of its September increase. For those with optimistic gas price outlooks for 2012, the latest data provides a challenge for the market given the current oversupply situation.

Much like death and taxes, well depletion will eventually overwhelm a field's productivity if drilling activity does not remain high. Low natural gas prices will, at some point, make the economics of drilling additional gas shale wells unattractive. Then we will see the onset of production declines that will lead to higher future gas prices. We may be starting to see that trend reversal emerging. The challenge for producers is to absorb the current agony of low prices while awaiting the future ecstasy of higher prices.


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