Natural Gas Debate: Is It Chicken Little or Alfred E Neuman

Abstract: While energy analysts express alarm at trends in the natural gas industry, the U.S. Department of Energy insists market forces are at work.

Analysis: Think of the discrepancy, affectionately, as Chicken Little versus Alfred E. Neuman.

The one says the sky is falling for future natural gas production.

The other responds: "What, me worry?"

The fact such a discrepancy exists shows the range of interpretation regarding trends in the natural gas market.

Right now energy analysts are arguing the Chicken Little view, expressing alarm at falling natural gas supply. This is evident in a recent outbreak of higher natural gas price forecasts. Analysts are boosting average natural gas prices ever higher, up from $5 per Mcf earlier this year to $6--and above--currently.

Indeed the major question right now for many analysts centers on sustainability. Is this a year-long scenario? Does it stretch through 2004, or does it last until liquid natural gas enters the market in a big way four or five years down the road.

For the first time since the summer of 2001, the term "multi-year upward trend" has seeped back into forecasts.

At the crux of the Chicken Little perspective is the principle of sequential decline, a phrase that simply means U.S. natural gas production is down six straight quarters, and continues to fall year-over-year.

Technically, sequential decline ended in the first quarter when production rose incrementally. Analysts say it was a false positive since fourth quarter production was artificially low after the October Gulf of Mexico hurricanes forced the industry to shut-in gas wells. EOG Resources estimates the two hurricanes suppressed U.S. natural gas production by 1.4 percent in the fourth quarter.

Either way, production was still down year-over-year, and will continue to be down versus the prior year for the balance of 2003.

While analysts offer the Chicken Little thesis, the U.S. Department of Energy (DOE) speaks to the Alfred E. Neuman side of the issue. The agency expects higher natural gas prices will generate better revenues for operators, who will spend that money drilling natural gas wells.

The agency also expects industrial demand to recover in the next 12 months and rise 1.5 percent next year. Elsewhere, the agency's most recent "Short-Term Energy Outlook" expects increased drilling levels will boost U.S. gas production 1.6 percent this year and another two percent in 2004.

So how can mutually exclusive scenarios coexist?

There are several areas where the two perspectives vary. The DOE says U.S. gas production declined 1.8 percent last year. Energy analysts argue production declines were much steeper, more commonly in the range of five to six percent. Analysts base their estimates on comparisons for the industry's largest natural gas producers domestically--typically four dozen firms who represent 70 percent of natural gas production. Many of these firms are witnessing sequential decline, sometimes on an accelerating basis.

In fact, analysts argue the natural gas supply is so short near-term--a shortfall estimated between 1.5 amd 2.5 bcf/d--that a train wreck is likely unless it is averted through price-induced demand rationalization.

And, in contrast to the DOE, analysts say the industrial sector is the most likely candidate for demand rationalization. Sectors that are price sensitive to natural gas include chemicals, fertilizers, paper, or primary metals. Each must either switch to more competitive fuels, or shut production down until the gas market returns to balance.

It is fascinating to review the different forecasting approaches.

The DOE argues the industry will have surplus gas productive capacity of about 5.6 bcf/d in 2003. This projection is based on a model first published two years ago in May. The model was updated recently for the DOE's "Short-Term Energy Outlook" and was posted on the agency's website.

The particulars are of interest. The model looks in depth at several major U.S. gas-producing regions. But the most significant point is its view of capacity utilization. The model involves a ratio between effective productive capacity and actual production. Effective capacity is the yield of wellhead gas within the constraints of different regional production, gathering, and transportation systems. It is what the system could produce at 100 percent utilization.

Actual production is the volume of gas generated at any given time. It is possible to calculate surplus gas productive capacity as the difference between actual production and effective productive capacity.

What's intriguing is the organic nature reflected in the model. Effective productive capacity is a dynamic measure that expands and contracts in a lagged response to drilling levels. If drilling stops, effective productive capacity declines a few months later. When drilling expands, effective capacity grows, according to the model.

When natural gas capacity utilization rises above 90 percent, price volatility enters the market. This can happen through declining supply, rising demand, or a combination of both.

The DOE says increased drilling in 2003 will expand effective productive capacity by 2 bcf/d with more than half the increase originating in the Rocky Mountains and Texas. Effective capacity remains static offshore where drilling levels are flat and infrastructure is constrained.

Ultimately, the combination of rising production from the growing base of new gas wells and expanding productive capacity creates a surplus buffer of 5.6 bcf/d for the market. Capacity utilization is a little under 90 percent for this scenario.

Here's how the DOE model worked historically. In 1998-99, lower commodity prices reduced drilling levels, leading to fewer new gas wells. According to the DOE, new gas wells contribute 25 percent of effective productive capacity in any given year. As capacity fell, low storage levels and stronger demand converged in late 1999, increasing utilization above 90 percent. Natural gas prices moved up, and operators reinvested capital in drilling.

New gas wells increased in number during 2000 and 2001. This expanded effective productive capacity, and utilization dropped back below the magic 90 percent level. Gas prices retreated, drilling dropped off, and gas completions declined.

By early last year, effective productive capacity began to erode.

The model indicates the industry currently is witnessing a rise in drilling volume in response to higher energy prices. The agency says drilling volume will rise further this year, creating an expansion in both actual production and effective productive capacity, bringing the market into balance sometime in 2004.

Few analysts would argue with the market-based model theory. Instead, the emerging consensus among analysts is more pessimistic about the resource. Tightness in supply is a chronic challenge, the argument goes. Ultimately, tomorrow's new gas well completions aren't going to have the same effect on a volume basis as yesterday's new well completions.

Who is right? Take your pick long-term. Shorter-term, it sounds as though the drilling contractor is going to be busy for the foreseeable future.