Analysis: For those who thought natural gas prices of $10 per thousand cubic feet (mcf) in 2000 were an anomaly, look again. An unusual set of commodity market permutations briefly catapulted Henry Hub gas prices into the $18 range last week.
Furthermore, Henry Hub spot prices averaged more than $10 during the last week in February.
That angst signals change in the natural gas fundamentals and indicates the long drought in field activity is ending. The drought was characterized by historically strong commodity prices, but flat rig counts.
The natural gas market has now evolved from excess supply in a low demand environment into a tight supply situation. The re-polarization occurred literally over the last 45 days as an extended bout of cold weather in gas-consuming regions of the country drained natural gas storage and taxed spot market capacity.
The change indicates the supply/demand equation has tilted back towards the supply side of the issue for the first time in a couple of years. And if supplies are down--storage is more than 30 percent below the five-year average--it implies a need for increased production. Face it: While mergers, acquisitions, and purchases alter an individual company's reserve size, the only reliable way to increase production organically is through the drill bit.
The first signs of increased demand for drilling services are now evident in the rig count where there has been a subtle, but steady increase since the first of the year. A Land Rig Newsletter study of changes in rig count over the last 90 days shows that a handful of large independents, plus one major company, are responsible for the increase in rig employment. As a group, the 15 most active E&P firms increased their share of the land-based rig count from a low of 30 percent to upwards of 35 percent in 60 days. Essentially, Anadarko, BP, Chesapeake, EOG Resources, and XTO Energy are hiring rigs. Ironically, some of the same companies who have complained about a lack of quality prospects are the same ones adding rigs at the moment.
So is the uptick in field work real--meaning sustainable--or is it a head fake? There remain a lot of "ifs" out there at the moment. To date, the war scenario has engendered caution across the business sector, which is also true for oil and gas. But rising rig counts say natural gas market fundamentals have changed enough to overcome the cautions engendered by the deteriorating international situation.
High commodity prices are providing a flood of free cash flow for operators. The issue becomes what happens to those rising cash reserves. Some operators will be allocating cash to balance sheet issues for some time to come, and that will cap the rate at which rig counts rise. Many operators made acquisitions or added debt during the up-cycle that peaked in 2001. The subsequent decline in share value exaggerated debt-to-capital ratios to unfavorable levels. And, while no one will talk about it, there is that lingering problem with industry leverage that was created off balance sheet.
Liquidity issues continue to impact the industry. For example, El Paso had been the most active land rig employer in the U.S. El Paso's rig employment increased from 17 units during the fourth quarter to nearly 40 units in the first quarter 2003. However, the company's financial challenges mean many of those units will lay down just in time to miss the benefits from the natural gas price spike.
Still, momentum from changing market fundamentals is strong enough that those idled El Paso rigs will be reabsorbed into an expanding market. The new fundamentals are already attracting first responders, and if commodity prices remain strong, others will follow.
In the shorter term, the market will force choices on consumers. During price spike events, people quit using the commodity. Fuel switching came into play two years ago, particularly during the first quarter 2001 when year-over-year distillate consumption rose a quarter of a million barrels per day (bbls/d), much of it imported from Europe. Fuel switching replaced up to 2 billion cubic feet per day (bcf/d) in natural gas demand and helped gas prices return to earth.
Fuel switching has not been a solution in the current price spike--at least not yet. High oil prices, coupled with the lowest distillate inventories in history--and strong distillate demand--make fuel switching problematic. True, distillate consumption is up one quarter million bbls/d versus last year, but demand for heating oil explains most of the change.
High natural gas prices also rationalized demand in a literal sense during the 2000-2001 event. The most common buzz phrase in natural gas during that time was "demand destruction," estimates of which ranged between 4 and 6 bcf/d. Much of that demand destruction originated in the industrial sector, including chemical and fertilizer plants, or the metals industry. Plant operators shut down production in the face of high natural gas prices. In some instances, aluminum manufacturers temporarily closed the plants, then sold gas supply contracts at a profit to other end users.
You can bet demand rationalization is coming soon. Nor is it difficult to figure out where. Low commodity prices and plentiful supply subsidized major gas-consuming industries like chemicals and fertilizers over the last 15 years. That era is coming to a close. Higher base natural gas prices are the new business reality and this sector will have to compete for higher-priced gas in the domestic market as the commodity arcs along the downward side of the depletion curve. Commodity chemical producers and other large gas industrial consumers will find themselves competing against cheaper foreign imports, which will result either in capacity downsizing, or moving production overseas.
Nor can the depletion effect be underestimated. Those analysts who track gas production by company report volumes are dropping more than one percent per quarter, and more than five percent year-over-year. Oil and Gas Advisory's Ian McKinnon chronicled the same trend underway in Canada.
The story for 2003 is that the nation will exit the winter heating season with the lowest natural gas inventories on record. It will require a 20 percent increase in gas availability this summer versus last summer to get storage levels back to the traditional 3 trillion cubic feet (tcf) marker. From a practical standpoint, it means adding 2.3 tcf of gas to storage in addition to meeting all spot market demands between now and early November.
This will be an uphill struggle. Depending on the analyst, the market is short natural gas between 4 and 5.5 bcf/d. Immediate balance must come either through fuel switching, demand destruction, or increased production. At some point, all of those factors come into play; though shorter term, the first two will be the more significant.
The last one implies rig counts will be higher this year than last, and likely higher still in 2004.
Associate Editor: Robin Beckwith
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