Musings: Is Resolution of Natural Gas Conundrum About to Emerge?



For most of this year, natural gas prices have moved counter to almost everyone's expectations -- falling while crude oil prices have risen dramatically.  The conventional explanation has been that natural gas production coming from the newly completed wells in the prolific gas-shale formations around the country is much greater than from traditionally located and drilled wells.  The unanswered questions are when will this phenomenon of more productive wells coming on stream end and why are producers continuing to drill ANY gas wells in a sub-$3 per thousand cubic feet (Mcf) world? 

Why are producers continuing to drill ANY gas wells in a sub-$3 per thousand cubic feet (Mcf) world?

Some producers have claimed that they have been scaling back their gas drilling activity lately, despite the recent uptick in gas drilling rigs, but the backlog of drilled-but-yet-to-be-completed wells is being worked down and that accounts for many of the prolific new wells coming on stream.  The answer to why producers are willing to drill and complete wells in today's low gas price world is answered by the strong contango that has prices for natural gas one year into the future selling at nearly $2 per Mcf higher than current fiscal spot prices.  The two charts below demonstrate this phenomenon.

Probably the more important chart is the one showing the relationship between the current futures price and the one-year forward futures price.  In that chart, the one-year forward natural gas price is divided by the one-month forward price.  Over the period since 1990, the mean of that calculation has been about 6%.  On the chart are also plotted lines showing +/- 2 standard deviations in the ratio.  As the chart shows, the ratio between the two forward prices now stands at more than 4 standard deviations above the mean. 

The ratio between the two forward prices now stands at more than 4 standard deviations above the mean

The conventional wisdom, as reflected by recent revisions of natural gas price forecasts for 2010 by several Wall Street firms, is that the one-year forward gas prices are more representative of the market than the current futures price.  In fact, some of these firms suggest they expect a significant fall-off in natural gas production later this year due to the cutback in gas drilling and coupled with an expected uptick in gas demand, the market will be short of supply causing gas prices to soar in order to trigger a stepped-up drilling effort to avoid a permanent swing to a gas-shortage environment. 

As we have shown is previous articles, the drop-off in gas-oriented drilling has not yet produced the supply response anticipated.  In fact, there has been virtually no fall-off in gas production as measured by the average daily volumes reported on the EIA's Form 914 survey of production data through June.  That scenario has proven to be a major disappointment for natural gas price bulls.  But as one price-bull wrote recently, we are seeing the fall-off in production; it just isn't being noticed.  This Wall Streeter suggests that if one plots the change in gross monthly natural gas withdrawals, the chart will demonstrate that a supply response to the lack of drilling is occurring. 

There has been virtually no falloff in gas production as measured by the average daily volumes reported on the EIA's Form 914 survey of production data through June

He further went on to say that if one examined the slope of the monthly change data, it would become even clearer how the supply response is developing and will shortly become a stimulus for rising natural gas prices.  His point is that for investing success, it is the rate of change (the first derivative) that drives stock prices.  This has proven true with respect to oilfield service and energy producer share prices in the past, but this is called "momentum" investing.  There will always be a point in time when the rate of change slows, which then becomes a signal of slowing earnings growth, although the reported growth rate may remain well ahead of historical company and industry rates and even greater than other industry sectors.  But as the earnings growth rate slows, "hot money" will be heading for the exit. 

His point is that for investing success, it is the rate of change (the first derivative) that drives stock prices

We thought we would examine this thesis, which is displayed in the next several charts.  The first one shows the absolute monthly volume of gross natural gas withdrawals.  What becomes clear from this chart is the shape of the monthly gas production data curve initially reflects the peak in drilling activity in the early 1980s and the eventual collapse in the energy business in the mid-part of that decade.  One can see the slow recovery in monthly gas volumes as natural gas prices were deregulated, but the restrictions on the use of natural gas as a boiler fuel and the surge in gas production created a supply glut depressing prices through most of the 1990s.  Slowly gas production volumes grew and then exploded in the past two years as demonstrated by the recent upturn. 

The monthly pattern is shown more clearly and more dramatically when one translates the monthly figures into daily totals for each month.  While proving the point that free markets and free prices act to stimulate supply if demand is present, the Wall Streeter relying on this data would point to the sharply downward sloping data for recent months (marked by arrows) as a sign of the downturn in the gas industry's supply response to lower gas prices.  His point is that the steeper the slope (angle of the arrows) is a reflection of the speed at which the industry response is happening.

While the visual presentation of the monthly natural gas withdrawal data over the past 30 years clearly shows the downturn in monthly and the daily gas production figures, we thought we would see what the actual monthly and daily volume change figures showed.  Here, the data presented a more challenging picture.  In both the monthly and the daily percentage change charts we plotted a linear trendline to see what pattern might be obvious.  While it is very difficult to see, the gross monthly data showed an ever so slight upward trend line above the zero line as production growth for the last 18 months has increased due to successful gas-shale drilling efforts.

The monthly daily production change chart shows no long-term trend or at least one that our eye-glass-challenged eyes could discern. But does it matter?

If the gas-oriented drilling rig count continues to rise, and the non-vertical count grows, then we are likely looking at continued healthy gas production volumes, albeit the month to month growth rate may slow.  Until the production growth rate turns decidedly negative, it is likely that gas prices will remain under pressure from the growing gas storage situation.  Even though the EIA has indicated that gas storage capacity has expanded by 100 Bcf this year, or about 2 ½ percent, the weekly storage injections remain very healthy and show no signs of slowing until they are forced to stop growing by the lack of storage space for the gas. 

Exhibit13"

The $64-question is whether the natural gas market has actually stepped off the edge of a cliff and when that realization sets in, it will be as if the industry is in a supply free-fall.  While that scenario is one natural gas price bulls would like everyone to believe might happen, there is substantial gas in storage, a growing number of shut-in wells and low-cost liquefied natural gas (LNG) supplies around the world to meet any supply shortfall.  We could experience a supply and price shock, but the probability is small in our estimation.  The greater energy industry risk now is the possibility of another downleg in the drilling rig count.  Once again we show the chart showing how similar the current rig count upturn appears to the 1981-1987 period.  This is not a forecast of what might happen.  It is a reminder of what has happened and how similar today's pattern appears to that past.

Exhibit14"
Creating a larger market for natural gas, especially in the transportation sector, is proving much more difficult to accomplish than initially believed

As long as the government continues to be actively involved in the energy business it is impossible to be totally certain as to how current trends might change.  As people involved in the domestic natural gas business know, government regulation in response to then current perceptions of the health of the market at any point in time shapes the future of the gas business.  At one point gas was considered too valuable to burn as a fuel because we would need it for our petrochemical and pharmaceutical industries.  Government regulations restricting gas as a boiler fuel contributed to more than a decade of flat and weak gas prices.  While proponents of the view that the country has huge untapped yet economically available gas supplies that can play a key role in helping to solve the nation's environmental and oil import problems seem to be making some headway in convincing politicians of the validity of their case, the legislation to achieve it doesn't appear to be moving forward.  Maybe that will happen, but it seems it will likely take a major change in attitude by the Obama administration or some external oil market event that highlights the security advantage of domestic natural gas.  Creating a larger market for natural gas, especially in the transportation sector, is proving much more difficult to accomplish than initially believed.  We believe natural gas should play a larger role in our domestic energy picture, but getting there may come in baby steps rather than giant strides.



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