Musings: Surprise Of 2011: Crude Oil Down And Natural Gas Up
Conventional wisdom calls for crude oil prices to average above the triple-digit barrier in 2011 and natural gas prices to continue its run in sub-$5/Mcf (thousand cubic feet) purgatory. What a surprise it would be if a year from now we looked back on 2011 as the year in which crude oil broke $100 a barrel but settled well below that level and that natural gas rallied to $6/Mcf and averaged above $5/Mcf. How could this possibly happen? Let's take a look.
But in various places and ways the global liquid fuel supply is growing
Global crude oil inventories, while coming down due to tax planning and increased winter demand, remain high. OPEC spare output capacity is about 5.4 million barrels per day, well above the one million barrels a day it had fallen to when oil prices soared to $147/barrel at mid-year 2008. While there have been a number of new large oil discoveries, especially in deepwater off Brazil and West Africa, most of them will not come on stream to help boost the supply picture next year. But, in various places and ways the global liquid fuel supply is growing. For example, the Bakken shale formation in North Dakota is experiencing a drilling boom and due to significantly greater flows from these new wells, the state's oil production has nearly doubled from 2008. Estimates are that North Dakota's oil production could increase by another one-third, or an additional 100,000 barrels per day by the end of 2011. More importantly, the growth in gas shale drilling in the U.S. is leading to increases in both crude oil and natural gas liquids production along with surging volumes of natural gas. The increased volume of natural gas liquids, outside of the crude oil quotas of OPEC members, has also added to global fuel supplies. And the most recent OPEC development is the announcement that Iraqi oil production has reached 2.6 million barrels per day, a 20-year high, with growing exports. Iraqi exports may become an issue in 2011 for OPEC if global demand growth moderates.
Oil price forecasters must look at more factors in more countries, most of which lack transparency compared to the U.S. and Europe
While supply is growing, the greater question for oil prices is the demand side of the equation. The bullish case for oil demand argues that America is no longer the driving force behind oil consumption growth as that mantle has been assumed by Asian developing economies. That means oil price forecasters must look at more factors in more countries, most of which lack transparency compared to the U.S. and Europe. Historically, oil demand growth in these developing economies has been spurred by price subsidies. The finances of many of these countries can no longer absorb those subsidies and we have seen and expect to see more countries cut or eliminate price subsidies. That means oil demand growth will become more dependent on economic growth, and energy usage will be subject to greater conservation than in the past.
We still have a weak economic recovery underway in the United States and there are serious economic and financial questions in Europe. As long as these large energy consumers are languishing, it is hard to expect a repeat of the 2-plus million barrel per day demand growth this year, which reflected a snap-back from the recessionary years of 2008 and 2009. The IEA is projecting oil demand growth of 1.2 million barrels per day in 2011, a growth rate consistent with the growth rate of the 1990s and 2000s. A last consideration is what happens to the value of the U.S. dollar. If the new Congress addresses the government's profligate spending and the country's long-term entitlement issues, the value of the U.S. dollar could rally undercutting the global price of oil.
The IEA is projecting oil demand growth of 1.2 million barrels per day in 2011, a growth rate consistent with the growth rate of the 1990s and 2000s
The real surprise could come on the natural gas side where the Energy Information Administration (EIA) recently projected that prices will remain below $5/Mcf until either 2019 (Henry Hub price $5.04) or 2023 (wellhead price of $5.15/Mcf). While the natural gas industry has experienced boom and bust environments in the past, most of the pricing variability was due to regulatory changes impacting natural gas consumption. The prospect of a decade of natural gas prices trading in the $4-$5/Mcf range strikes us as unreal. Governmental and societal emphasis on using cleaner energy argues that natural gas will play a greater role in U.S. energy supply than it currently does. Even though we have huge deposits of natural gas, especially due to the successful exploitation of our shale gas formations, many of these deposits will need substantially higher prices to be economic. The rush to lease up the acreage covering these shale formations and to hold them by drilling wells and producing gas has contributed to the current gas oversupply situation. That will pass as the land grab mentality ebbs and rational economic analysis exerts greater control over producer spending.
The prospect of a decade of natural gas prices trading in the $4-$5/Mcf range strikes us as unreal
We may be seeing the first signs of that shift in producer mentality in the EIA's latest release of its estimate of natural gas production taken from its Form 914 survey. After surging to a new record high for Lower 48 land gas production in September of 60.37 Bcf/d (billion cubic feet per day), the month's production was subsequently
revised down to 59.94 Bcf/d, still a new record. The initial production estimate for October is 59.79 Bcf/d, a sequential decline of 0.15 Bcf/d. Moreover, gas production from the Gulf of Mexico in October was flat with September at 5.95 Bcf/d versus 5.93 Bcf/d. October's Gulf of Mexico production was almost 1.0 Bcf/d lower than a year ago (5.95 Bcf/d versus 6.94 Bcf/d) and on trend with the long-term decline in offshore gas production.
While it remains early to forecast a significant reduction in onshore natural gas production, we are witnessing a shift away from gas-oriented drilling. The chart below (Exhibit 3) shows the monthly average number of rigs drilling for natural gas through October but provides only a hint of the reduction in gas drilling. But if we look at the latest weekly rig count numbers from Baker Hughes (BHI-NYSE), we find that since early September the number of drilling rigs targeting natural gas has declined by 50, or about 5%.
If one only focuses on the number of drilling rigs drilling horizontal wells, there doesn't appear to be much change. What is missed, however, is the shift underway from drilling horizontal wells focused only on dry natural gas and toward drilling horizontal oil wells and wells targeting high liquids volumes in the natural gas stream. Given the relative economics of drilling exclusively for dry natural gas versus crude oil and/or high liquids-content natural gas wells, we assume the current shift in focus will not reverse anytime soon.
Since we are not a betting person, we are not providing odds on our oil and gas pricing surprise scenario happening. October's gas production data represents only one data point. Some people worry about the estimate being revised upward when November's data is released, but we would point out that in every month in 2010 so far, the revision of the initial monthly estimate has been down. One needs to go back to December 2009 to find an increase in the monthly revision, and that was by only 0.01 Bcf/d. The prior two months saw positive revisions each month of about 0.20 Bcf/d. So while there may be a valid concern about the possibility of an upward revision, recent history suggests it would mean a reversal in trend. The trend in natural gas drilling activity this fall suggests a reversal is unlikely. That said, we suggest people should ponder our oil price surprise scenario as they contemplate energy business and investment decisions.