Musings: Choking on Natural Gas, But Is It About to End?

The September 2009 natural gas futures contract expired last Thursday night with the price setting another 7-month low of $2.843 per Mcf. The October 2009 contract that became the new frontmonth contract was off 14.4 cents in early trading Friday morning, but still held above $3 per Mcf. It closed the trading day still slightly above $3. Whether the new front-month gas contract can sustain a price north of $3 per Mcf for any extended period of time, given the swelling supplies of natural gas in inventory, remains a huge question mark.

Estimates are that total natural gas storage capacity in the U.S. ranges somewhere between 3.6 Trillion cubic feet (Tcf) to 3.9 Tcf. Reports are that the U.S. Energy Information Administration (EIA) will be releasing an updated study on gas storage in this country either this week or next, and it reportedly will show about a 100 Bcf increase in domestic capacity. As of last week, the EIA said in its weekly gas storage report that the volume of working gas in storage, meaning gas available for consumption this winter, had reached 3.258 Tcf or anywhere from 83.5% to 90.5% of estimated industry storage capacity. That volume of working gas in storage would satisfy 54 days of average U.S. gas consumption, but only a small portion of gas storage volumes is used each winter day as there remains a huge supply of flowing gas to help meet the daily demand.

The problem for the natural gas market has been that gas production continues to remain strong due to the continued development of new producing wells from the highly prolific gasshale plays sprouting up around the country. The increase in gas production volumes was thought to have been arrested by now as a result of the nearly 50% cutback in gas-oriented drilling since last fall. Unfortunately, E&P companies continue to drill highly prolific wells in the gas-shale basins due to their estimated lower finding and development cost allowing them to generate profits in a lowprice environment and in order to retain expensive mineral leases signed in recent years. The impact of these new prolific wells, coupled with the decline in domestic gas demand due to the weak economy, has been greater than expected weekly gas storage injections. As shown in the accompanying chart, the weekly storage injections (in red) for 2009 so far have almost always exceeded the five-year average weekly injection figure (in blue). Injection volumes for the past two weeks have been below the five-year average, but still above Wall Street's expectations.

As the chart shows, if gas injections continue to average in the 50- 55 Bcf range until the winter heating season arrives and when gas begins being withdrawn, storage capacity will reach full capacity. There are essentially 10 more weeks of injection season and at the current injection rate, the industry will be trying to stuff another roughly 550 Bcf of gas into the already jam-packed facilities around the country. The real problem as we approach full capacity is that storage availability in broad geographic regions and even in local areas can reach full capacity well before the entire system, causing supply system discontinuities and pricing anomalies.

The recent announcement by Newfield Exploration Co. (NFX-NYSE) that it was shutting in about 2.5 Bcf of third quarter gas production is a sign of the stress producers are under to avoid selling gas below finding and development costs while still trying to satisfy Wall Street and investors for growing corporate production metrics. As we have written about before, other producers such as Chesapeake Energy (CHK-NYES) have said they do not plan to curtail production and bear the financial brunt of reduced revenues while other producers benefit. Chesapeake expects production cutbacks to occur at some point, driven by industry-wide factors, and to be spread broadly across the E&P industry.

Exhibit2"

The natural gas storage business is a challenging one in this country. The cost to build new facilities is not cheap. Additionally, it often takes a long time to construct new facilities. This means storage facilities may be constructed in response to a volatile pricing period and planned to capture some of that volatility, only to find that the market is changed by the time the facility is ready for operation.

There are five types of storage facilities as shown in the above exhibit and these facilities are spread across the country although there tends to be a greater concentration in gas-consuming regions since the facilities are planned to help gas pipeline and local distribution companies deal with winter demand surges.

What can straighten out the natural gas market? Short of a surge in economic activity that brings back industrial demand previously destroyed by high and volatile gas prices, it is going to take greater capital discipline on the part of E&P executives. Yes, an early cold winter could also help, but that will merely create a short-term blip in gas prices as weather has a tendency to change rapidly. Additionally, it is difficult to envision Wall Street becoming enamored of an investment sector where E&P executives become weather forecasters. However, as the E&P industry draws closer to the expiration of gas futures hedges put in place when natural gas prices were $8 and above, which protected producer cash flows in this low wellhead price period, E&P producers may be forced to reexamine their future spending plans. Unless gas production falls quickly helping to boost gas prices, we expect to see another downturn in the rig count, or at least for those rigs drilling for natural gas.

The recovery we are witnessing in today's rig count is eerily similar to the pattern that occurred in late 1982

We will not attempt to describe how the E&P industry came unglued from its frothy environment of pre-September 2008, but a picture is worth a 1,000 words. We have superimposed the 2008-2009 Baker Hughes active rig count on the rig count experienced in 1981-1987. Clearly today's rig count is but a fraction of what it was at the end of the industry boom of the late 1970s, but that reflects the greater drilling productivity the industry has achieved from drilling rigs today versus those in the past. There is also a substantial difference in the number of E&P producers and drilling rig companies operating in the two periods. But the recovery we are witnessing in today's rig count is eerily similar to the pattern that occurred in late 1982.

Exhibit4"

The late 1982 rig activity recovery was followed in 1983-1985 by periods of both rig recoveries and downturns as oil prices steadily slipped out from under OPEC's control and U.S. natural gas remained under price regulations. The industry then seemed to find stability in drilling until the oil market entered a freefall in early 1986 as Saudi Arabia elected to not only stop supporting the OPEC posted price at the time but the Kingdom elected to open up its wells to teach "cheating" fellow OPEC members a lesson.

Talk about a "teachable moment" in history! It took the global energy industry more than a decade to recover from that moment and Houston was particularly hard hit by its fallout. We certainly are not suggesting we are headed for a repeat of that era, but the current rig upturn could prove to be short-lived and followed by another downturn if natural gas prices continue to fall. We present this scenario merely as food for thought, but it is enough to keep us awake at night.

G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.

WHAT DO YOU THINK?

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Carlos Luna | Sep. 6, 2009
We must develop more systems to use natural gas in motors as in Brazil. Thus, the price of natural gas will be able to increase and many jobs will be created for an increase in the gas rig count.

chris eckels | Sep. 4, 2009
There would seem to me a couple of fundamental differences in today's climate as opposed to the 1980s exploration and production climate.

First, the recession we are in is much deeper than any this country has experienced in any baby boomer's lifetime. When we will recover from the recession, how quickly we recover and to what extent we recover is an unknown.

Next thing that manifests itself as to drilling, exploring and producing gas and oil that was not present in the 1980s, as it is now, the power of the green movement. The greenies have amassed a voice in Washington to the extent they now have a significant degree of power and are in an ever present mode of imposing that influence onto all of us.

We shall see, however, the Obama administration has said that natural gas will be one of the key ingredients to be utilized in bringing the country's economy back to stability. I have to ask, is this lip service as was the case with Clinton's administration's "natural gas is the administration's fuel of choice?"

The greenies and the president could actually help the natural gas industry if they put in place incentives/requirements promoting gas use. I am a skeptic though when it comes to government and all who play in that arena.

Dan Cuneo | Sep. 4, 2009
There are probably hundreds if not a few thousand depleted offshore wells and wells that are in the Marshes of Louisiana and Texas. The offshore wells have a net work of pipelines that were used to transport the oil/gas from the well to shore. Why can't we reverse the process and compress the gas back into the depleted formations that have since been capped? Extract when needed, replenish when we are in surplus.

Kevin Lynaugh | Sep. 4, 2009
Energy is the emerging issue. Must be a balance between fossil, methanes, sun, wind, water, and efficient use of these fuels to balance the volatility of economies. I'm in the marine transportation industry and we are looking more to dual fuel vessels in order to avoid being hostage to short or costly supplies. If cheap energy is not available not sure how the economic engine will continue on a smooth course without the ups and downs. Hopefully the governments see this and provide the leadership to make this happen so we have calm seas.

Chris Christensen | Sep. 3, 2009
Why have the producers not expanded their market through commercial transport instead of pipelines? Many remote areas would utilize natural gas instead of propane if it were available. Utilization of transportable storage would allow expansion of storage without construction. There are 20-40,000 railcars going unused that could be parked in remote areas such as Northern Nevada. Provides local jobs and rapid response flexibility.

Nick Grealy | Sep. 3, 2009
I don't think rig counts from 1982 can be relevant today. First off, the success rate per rig is much higher today than it was then. 3D imaging etc has taken out a lot of the crossed fingers of days gone by. Not as much fun, and far greater emphasis on "avoiding risk," but also avoiding those great successes that happen through luck as well as skill.

Secondly, rigs are horizontal these days aren't they? They were all vertical then, which was much more of shooting blindly, whereas horizontal drilling evidently can cover a far greater number of possibilities.

Loren Bly | Sep. 2, 2009
1st--The Industrial demand is not coming back as "Industry" in this country is largely dependent on the liquidating Auto Group and conventional plastics; Wood and metal based production is in the 3rd world.

2nd--The LNG imports are subsidized by rogue nations who do not need to recoup "Profit" as defined by our economic system as they can ignore their finding and depletion costs just to receive some dollar payment over the shipping costs--We need an import surcharge on all LNG.

3rd--Our Fed govt. still refuses to support the logical shift to Natural gas as the accepted fuel of choice as the Environmental lobby still believes in the false economy of the electricial vehicle fuel footprint. Please support the Pickens plan's practical adoption of Natural gas and the modest federal grants for NG refueling facilities.

4th--Shale production is prolific and is required by most major E & P developers to hold their massive newly leased acreage positions in the next five years.

SUMMARY--NATURAL GAS PRICING WILL STAY DEPRESSED FOR THE INTERMEDIATE TERM THROUGH 2012.

JBC | Sep. 2, 2009
As mentioned in a prior comment, why not more use of natural gas domestically for mass transit, power transmission, personal use, etc.? I as many can remember drilling rigs (old Waukesha engines) that ran LNG, why not run what you drill for? It's here, we have it, and we have the manpower and equipment to do it. When will we start running this country like a business instead of a benevolent empire? If we don't supply it the Chinese will, and at what cost to us?

BW | Sep. 2, 2009
We have our "greeners" to thank for a dirty fuel based on nothing but Al Gore and David Suzuki's empire building. We worry about alternate energy source IE Nuclear power. Why not use some natural gas to fire more generators? Even when the costs go up, we would not have to deal with nuclear waste and will allow us more time to find a way to dispose of the waste.

BGP | Sep. 2, 2009
The scenario today is much different than in the 80s. Namely, in the 80s North American oil was too expensive to develop relative to OPEC's oil. In the current case North American gas is cheap to develop, so the rig count can recover somewhat and the industry has a long future. Now when LNG starts pouring into North America, that is a different story...

PDM | Sep. 2, 2009
I would like to see you expand your discussion to include the influence of the expanding LNG business. As more of our gas supply is augmented by incoming LNG the downward pressure on natural gas prices in this country becomes greater.

James Hersch Prof. Geologist | Sep. 2, 2009
A significant number of wells are awaiting pipeline hook-up. The monthly production of gas is still rising despite the dramatic fall in domestic rig count. The associated gas from new oil production in the Gulf of Mexico is also coming online. The industrial demand sector has to rebound to sustain an increase in gas prices.

CJ Reed | Sep. 2, 2009
A market for gas can be created by the use of compressed natural gas for vehicles, which is wide spread in Brazil for example.

With the wide spread use of trucks (i.e. F-150s) the fitting of the gas gas tank in the back of the loading platform is an easy modification.

If the USA still imports gasoline, then these is the saving.

I know Europe (mostly diesel powered in cars as well as heavy goods)and Brazil export to the USA.



Peter B. Macalua | Sep. 2, 2009
Your analysis of the current depressed prices of gas and the future attractiveness of investments in this sector can only be solved with outside the box thinking.

In this regard, any marketing guru should realize that the way out of this predicament of bust and boom scenario, is to accelerate the development and construction of DME (di-methyl ester) plants near gas collecting regions to substitute and supplant gasoline and/or diesel production.

In short, we should produce gasoline/diesel supplants from gas and not from crude oil.

This way is another angle of looking at the great Pickens Plan for the US to finally attain imported oil independence.

mW | Sep. 2, 2009
Great Article. but in regard to storage -- perhaps you mean this report released at end of August... http://www.eia.doe.gov/pub/oil_gas/natural_gas/feature_articles/2009/ngpeakstorage/ngpeakstorage.pdf

Herman | Sep. 1, 2009
I see that some activity is stirring up but some companies are still suffering. The companies with rigs paid for and old are able to get their rigs working at the industry's low prices; but the companies with the new more capable rigs can't get work for the low prices without sacrificing workers only later to have to deal with increased work loads and inexperienced hands that make the jobs unsafe.


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