Whatever Happened to the Natural Gas Crisis?

All concepts deserve rigorous challenge to test their mettle. The "natural gas crisis" scenario is no exception.

It will generate few headlines this Thursday, but when the Energy Information Administration releases gas injection numbers through October 31, look for wintertime natural gas storage to end the traditional refill season about three percent above the five-year average.

Furthermore, with above-average temperatures for much of the central U.S., natural gas will continue to flow into storage as November gets underway. Natural gas storage could very well enter the winter at the high end of the historical range.

It is an anticlimactic conclusion to this summer's natural gas story.

Just six months ago, there were dire predictions that the industry would be unable to replenish winter supplies because of a steep drawdown in storage levels in the colder-than-normal winter of 2002-03. Storage levels were 46 percent below five-year averages as recently as April.

However, no one is going to freeze to death this winter--or next--because of natural gas shortages. And the future for natural gas looks benign when one anticipates the expansion of the natural gas industry to the farthest reaches of North America over the next decade, followed by globalization of the natural gas marketplace thereafter through LNG.

Shorter-term, gas prices may be a different story for crisis proponents. During cold weather events, spot prices for natural gas are going to rise. But it is misplaced analysis to associate the term "crisis" with occasional peak events in spot market pricing. While prices of $10 per million cubic feet have been exceeded twice in the last three years, those events are notable for their brevity rather than their regularity.

The marriage of the terms "natural gas" and "crisis" first grabbed national headlines outside the oil and gas industry in early June following Federal Reserve chairman Alan Greenspan's testimony before various House and Senate committees. Mr. Greenspan discussed a potential future natural gas crisis given an extraordinary set of circumstances.

Web search engines combining the words "natural gas and crisis" produced hundreds of thousands of hits within two weeks of Mr. Greenspan's testimony.

The hits are nearly as numerous today, but few of the articles have recent dates.

Indeed, when Mr. Greenspan spoke, gas prices were well above $6 per million cubic feet as the industry rushed to generate gas to replenish depleted wintertime storage.

Low storage levels further fueled anxiety levels.

Today, natural gas prices are 30 percent less.

There are two components to the "natural gas crisis" scenario. The first is short-term and related to natural gas storage. The second is a longer-term manifestation in which conventional North American supplies decline while demand expands 30 percent or more--ostensibly for electrical generation.

One can debate the latter ad nauseam. The one fact emerging from the present situation is that the U.S. is witnessing the end of inexpensive natural gas, which existed in surplus for nearly 20 years. Eventually, an infrastructure of consumption based on artificially low prices grew up around the commodity, first in the industrial sector, later in electrical generation.

That era is ending.

In its place is a new era where gas prices have realigned to reflect the actual costs of producing--and consuming--the commodity. Both the 12- and 18-month futures strip suggest gas prices will remain in the mid-$4 range into 2005. Most financial analysts are predicting the same at least through 2004.

While there is little $2 gas left for production in today's market, the story is much different at $4 per million cubic feet. A recent study by Raymond James & Associates' oil and gas group theorized that E&P firms were reaping a 50 percent internal rate of return (IRR) under present commodity prices--even though finding and development costs (F&D) had risen significantly for operators.

Get an operator to buy you a beer. These days, the E&P industry is living in the best of all worlds. It is a fortuitous combination of high commodity prices coupled with flat field costs. This scenario is generating excess free cash. For the first time in modern history, operators are only partially reinvesting the proceeds from current commodity prices back into field work. Previously, operators invested 100 percent of available free cash flow--plus some--during high commodity price events. The figure now is closer to 70 percent. Excess cash flow is being allocated to clean up balance sheets or pay down debt, or directed to war chests for future merger and acquisition opportunities or property purchases.

In fact, operators have met storage targets and spot market needs using only part of their free cash flow. That hardly describes an industry in crisis. To the contrary, the oil and gas industry is a healthy business that is able to meet the challenges set before it.

Industry indicators traditionally understate the oil and gas industry's capabilities. Here are four reasons using the term "natural gas crisis" overstates the present situation.

First, the U.S. Department of Energy's Energy Information Administration understated the level of gas moving into storage this summer because its survey sample was only partial. The EIA revised its methodology in October, expanding the size of the sample and essentially adding another 37 billion cubic feet to storage on top of the 87 billion cubic feet that had shown up in monthly reports as recently as August.

Secondly, there are more rigs actively drilling for oil and gas than the non-proprietary weekly rig counts document. Land Rig Newsletter studies consistently show the Baker Hughes rig count understates activity by 20 percent--or more--depending on where the industry is in the oil and gas cycle. That activity will show up as strong gas production.

Third, there is greater industry capacity in terms of rig availability in the land-drilling sector. The industry could add another 200 rigs given reasonable time to gear up, though it is not clear those rigs will be necessary in this cycle.

Fourth, the industry is making remarkable progress on efficiency. In East Texas, for example, time savings of up to 40 percent have been reported on eleven 13,000-foot wells in hard rock country over the last two years. Better bit technology and greater mud pump horsepower are frequently cited as reasons. Furthermore, contractors have gotten better at rig moves, which shaves downtime out of the picture.

Preliminary information from RigData shows drilled footage in major U.S. land markets during the third quarter 2003 reached the same level as the third quarter 2001, the period that coincided with the peak in the 2000-01 cycle.

But it was accomplished with only 92 percent of the 2001 rig count, according to the Land Rig Newsletter.

Finally, talk of future crisis is predicated on unrealistic projections. The fact is, U.S. gas consumption has remained flat for nearly six years, with consumption gains in one sector offset by price-induced cutbacks in other sectors. But the theory of a future natural gas crisis is a story for another day.

In the meantime, debate bounces back and forth between the financial industry and the federal government over whether annual natural gas production is declining. The financial folks are using estimates based on partial samples--the same technique that resulted in understatement of the EIA's storage number. However, government data is based on comprehensive surveys of oil and gas firms through required federal reporting.

Unfortunately, the results of those surveys lag the general market by three to six months at the earliest and are subject to revision up to two years later based on industry year-end reporting requirements.

While the jury is still out, the odds favor Uncle Sam on this issue.

Meanwhile, with $16 to $18 billion in tax incentives working their way into the omnibus energy bill now in House/Senate conference, the most likely natural gas crisis facing the industry during the next two years may well be overproduction.