In recent weeks, Wall Street has been shifting its energy focus from crude oil to natural gas as the price of the latter has become historically cheap. The first signs of global economic recovery spurred investors to jump on the energy and materials stocks. The logic was that any increase in economic activity would require an increase in demand for industrial-related commodities and energy and their prices would rise. As we showed in our last Musings issue, industrialized commodities have been leading the recent rally in prices. The greatest price laggard of the 14 commodities we follow was natural gas, which through the end of May was down 44.3%.
The heat content ratio (British thermal units) between a barrel of crude oil and a thousand cubic feet (Mcf) of natural gas is 5.6-to-1. For ease of analysis, most energy pros and investors use a 6-to-1 ratio to translate volumes of oil or gas into the comparable fuel for purposes of estimating reserve values. This heat content ratio has seldom been achieved price wise in the marketplace as many factors interrupt the straight heat value proposition. For example, natural gas must move through a pipeline from its production source to where it is burned. The lack of adequate pipeline capacity or the absence pipelines to consuming areas can limit market opportunities for natural gas and depress the relative price comparison.
Other factors that can alter the heat-content price ratio include the lack of storage for competing fuels such as petroleum or coal; environmental restrictions on the burning of dirtier fuels; and concern about the availability and price of future supplies. All of these issues have at one time or another disrupted the pricing ratio from more closely matching the physical value of competing fuels.
Over a long history of gas and oil price competition in this country, the average ratio has been 9.3 times - meaning that crude oil prices were slightly more than nine times the price for natural gas. That historical norm is shown in the chart of the ratio of the wellhead price for natural gas compared to the first price paid for oil by refiners during the period from 1976 to May of this year based on monthly price data.
What the chart shows is that natural gas is almost as cheap compared to crude oil as it has ever been in the past 33 years with the exception of the time of the first Gulf War and during the oil price explosion in response to the 1979 Iranian revolution, the holding of American hostages and the withdrawal of oil supplies from the world market. If one goes back to the mid 1970s, oil was more valuable because natural gas was under significant use restrictions. Those restrictions followed the supply crisis precipitated by earlier federal government limitations on the price of gas that caused companies to stop seeking supplies for the interstate natural gas market.
Today, natural gas is cheaper than it was in the 1980s and 1990s when supplies were plentiful and demand was restricted. Those years saw natural gas prices in the $1.50-$2.50 per Mcf range when oil sold somewhere in the mid-teen or mid-twenty dollars per barrel, or about a 10-times ratio. Since January 1994 to now, the average price ratio of crude oil to natural gas is 8.5 times. Today, natural gas is selling in the $3.75-$4.00 per Mcf range while oil trades for about $70, making the resulting price ratio closer to 15 -18 times, or nearly twice the 15-year average. While the current ratio is calculated by comparing the futures prices for crude oil and natural gas, they do not totally reflect the economic realities of oil and gas as in the longterm historical comparison reflected in Exhibit 5.
Why is natural gas priced so cheaply in today's energy market? One has to conclude it is all about supply and demand. The imbalance between the two price determinants is behind the move to "Buy natural gas and sell crude oil" trade recommendations that started emanating from Wall Street brokers and commodity traders in the past few weeks. Part of the rationale for the trade was the belief that natural gas supplies would begin to decline as the downturn in the rig count curtails the petroleum industry's drilling as many new gas wells, especially since natural gas prices are so depressed compared to their levels of last year. This means that less new gas should come into the market, slowing the supply growth until it eventually declines leading to higher gas prices.
A chart on natural gas industry economics prepared by analysts at Bernstein Research tends to support the view that the rig downturn will lead to cutback in new gas production. As they show, spot natural gas prices have fallen below their estimate for cash costs, and well below their estimate of the marginal cost to find new gas supplies. In their analysis, there have only been a few periods when natural gas prices rose to levels that destroyed demand - and almost all of those times were during periods of conflict or natural disasters. On the other hand, for almost the entire ten-year span from 1993 to 2003, natural gas spot prices hung close to the estimated cash cost for creating new supplies. The chart helps demonstrate why it was so hard to be in the exploration and development business during the 1990s.
The global recession and credit crisis along with the deteriorating economics of natural gas exploration and development in the face of a continuing rise in gas supplies has combined to send the U.S. rig count into a depression. Since the industry peak in late August 2008, the total rig count has fallen by 1,155 rigs (as of June 12th) for a decline of 57%. Rigs dedicated to natural gas drilling have fallen by a similar percentage amount or by 921 rigs in the period. The share of the total working rigs drilling for natural gas has fallen slightly to 78.2% from 79.1% at the peak. This would certainly suggest that operators have not been overly dissuaded by low gas prices to cut back by a greater amount their gas-oriented drilling activity.
In fact, the data for the types of drilling done since the peak in late August 2008 shows that vertical rigs drilling have fallen by 67% from 1,017 to 331. At the same time, horizontal rigs, mostly associated with drilling the prolific natural gas shale formations in this country, are down only 39% from 626 rigs to 381 rigs while directional rigs are down 58% to 164 from 388 rigs.
Based on the expectation that the prolific natural gas shale formation wells experience declines of 60% - 70% from initial production by the end of their first year of operation, the slowdown in complex drilling (horizontal and directional wells) suggests that by 2010 the U.S. should experience a decline in natural gas production. That would be a welcome development for natural gas producers who are struggling with low gas prices due to rising production, demand destruction due to the recession, and growing supplies of liquefied natural gas (LNG).
Since early 1999, the U.S. gas rig count was about 400 and daily natural gas production was around 63 billion cubic feet per day (Bcf/d). With the exception of the industry recession of 2001-2002, the gas rig count marched steadily higher reaching about 1,600 at the recent 2008 peak. The four-fold increase in the rig count has been only able to grow daily gas production by roughly 10 Bcf/d, or about 16%. But virtually all the production growth came in the period since 2007 as the technical success of the various gas shale plays around the country brought significant new production. This is the challenge the domestic gas industry faces - can gas production growth be choked off without destroying gas prices in the interim and setting up the country for a new price spike?
While a drop in drilling and eventually a decline in natural gas production, the most important variable in the equation is the economy. If the U.S. economy experiences a recovery in both the housing and automotive industries, then the gas industry should be able to reach equilibrium sooner than many expect suggesting the natural gas trade could be very profitable. On the other hand, a weak economic recovery could doom the domestic natural gas and oil service industries to an extended, challenging and less profitable environment.
G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.
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