Musings: Natural Gas Price Rebound Heat Driven; Supply Still Grows

After peaking at $6.01 per thousand cubic feet (Mcf) on January 6th, natural gas futures prices steadily fell until they bottomed at $3.84 on March 29.  From that point gas prices rebounded to above $4/Mcf and traded in the low $4 range for the next month.  Gas prices began to move higher in response to hotter than normal temperatures finally reaching a near-term peak at $5.19/Mcf in mid June.  Since then, gas prices have fluctuated wildly but generally have remained in the upper $4/Mcf range as continued supply growth battled hotter weather and hurricane supply-disruption concerns.  The weak U.S. economic figures recently reported have begun to weigh more heavily on gas prices. 

Exhibit 14.  Gas Prices Have Rallied Recently
Gas Prices Have Rallied Recently
Source:  EIA, PPHB

Last week the Energy Information Administration (EIA) reported their April monthly natural gas production data taken from its monthly form 914 survey of producers.  Earlier this year, the EIA revised its data collection and analysis procedures related to this information designed to improve the accuracy of its estimate.  Despite a hoped-for major data revision to support those with bullish natural gas price expectations, the new gas production estimates were barely changed.  As a result, the bullish gas price case that rested on falling production due to a decline in working gas rigs since the fall of 2008 was undercut by the lack of any meaningful revision in the supply data. 

Exhibit 15.  Gas Production Onshore Continues Growing
Gas Production Onshore Continues Growing
Source:  EIA, PPHB

The April 914 survey showed that there was about a 0.3 billion cubic feet per day (Bcf/d) increase over the March production estimate, a mere 0.5% increase, for total Lower 48 land gas production .  Year over year the growth in natural gas production was 2.0 Bcf/d, or a 3.5% increase.  Analysts looking for a supply response due to fewer rigs drilling were encouraged by the lower production growth.  For most of this year, the monthly production increase has averaged about 0.8 Bcf/d per month, so the April gain was encouraging.  While natural gas production on land has continued to grow, the amount of supply coming from the Gulf of Mexico has declined.

Exhibit 16.  GoM Production Continues Trending Lower
GoM Production Continues Trending Lower
Source:  EIA, PPHB

The problem is that natural gas drilling activity has not declined in response to weaker gas prices this spring.  The number of rigs drilling for natural gas in the U.S. has increased by about 200 since the start of the year, marked by the red line in Exhibit 17.  There are about 275 more gas-oriented rigs drilling today than a year ago, so there has been some moderation in the pace of increase in response to low gas prices.  An even more important positive for gas drilling is that the gas-oriented drilling rig count has remained essentially flat for the past three months.  The problem for production and gas drilling is that capital continues to flow aggressively into natural gas shale basins as new producers clamor to establish initial acreage positions in the hottest production trend in North America and established producers try to expand their lease holdings.  Lease exploration timetables have become the controlling factor for gas drilling activity as producers are reluctant to lose the money they have paid for the right to drill, even though current gas prices are nowhere close to supporting the economics of current drilling projects. 

Exhibit 17.  200 More Gas Rigs Since January 2010
200 More Gas Rigs Since January 2010
Source:  EIA, PPHB

A recent posting on the web site, The Oil Drum, discussed the views of B. J. Doyle, the vice president of operations for a small Houston oil and gas producer.  He discussed the importance of reserves over production as the driving force for company actions.  Since Wall Street tends to value oil and gas producer stocks on the basis of the worth of their reserves, producers should be doing the same with their prospects.  Drilling decisions should be based on the net present value of the production versus the cost of drilling the well.  A key ingredient in that determination is establishing the discount interest rate for valuing future revenues.  For the oil and gas industry, that interest rate will range somewhere between 10% and 15%.  That number can significantly impact the present value of the reserves.  Mr. Doyle pointed out that his company usually doesn’t consider pursuing a prospect unless the present value ratio relative to the cost of drilling the well is six or more.  He said in periods when competition for prospects is high, the net present value ratio will often drop to as low as three or four.  Recently, he has seen public companies drill when the ratio has fallen to one. 

The BP oil spill in the Gulf of Mexico has boosted prospects of the government increasing its backing for more natural gas consumption at the expense of petroleum.  Unfortunately, the federal government is also strongly backing other renewable fuels and electric vehicles.  There have been strong efforts by natural gas producers to convince politicians both in Congress and state and local governments to increase incentives for building and using more natural gas-powered vehicles.  The need for new natural gas supply infrastructure to boost its use as a transportation fuel will require significant investment and time.  According to the International Association for Natural Gas Vehicles, at the end of 2009 the U.S. had 110,000 natural gas vehicles out of a total vehicle fleet of 234 million units.  For natural gas vehicles to impact gas consumption in any meaningful way will require many years. 

The recent MIT study on the future of natural gas in its chapter on demand discusses demand for natural gas vehicles.  As the study points out, there is only one factory-produced compressed natural gas (CNG) vehicle, the Honda GX, available in the U.S.  That model has an incremental cost relative to its gasoline powered equivalent of $5,500.  Converting a gasoline engine to a CNG one costs about $10,000 but a significant portion of that cost is subsidized by state governments.  These figures suggest that the incremental cost of a CNG vehicle is closer to the $7,000 figure in Exhibit 18.  As the information associated with that exhibit shows, the current spread between CNG and gasoline on a per gallon basis is $1.30, putting it close to the $1.50 figure.  Together, for the average driver who drives 12,000 miles per year, it will take roughly 12 years to breakeven on a CNG vehicle purchase unless the buyer is provided significant subsidies.  For fleet vehicles that drive 35,000 or more miles per year, the breakeven period is closer to four years that could be reduced further with tax breaks.

Exhibit 18.  Nat Gas Vehicle Cost Keyed To Miles And Fuel Cost
Nat Gas Vehicle Cost Keyed To Miles And Fuel    Cost
Source:  MIT Study On The Future Of Natural Gas

Natural gas is also being pushed as the preferred backup fuel for wind-powered electricity production.  While that is an attractive use, it does not assure steady demand growth as gas consumption will be more volatile as it substitutes for highly volatile wind energy. 

Outside of pricing, the greatest challenge for natural gas supply growth is the potential for restrictions on drilling and completing wells in natural gas shales.  In the Barnett gas shale area in central Texas, citizens have been protesting deterioration in air quality due to leaking natural gas-powered compressors and possible releases associated with gas wells.  On the other hand, in the Northeast – principally Pennsylvania and New York – citizens are raising concerns about possible water pollution due to gas well drilling and completion activity.  A bill was recently proposed to the Pennsylvania legislature to institute a moratorium against natural gas drilling in the Marcellus gas shale formation.  The sponsor suggested that the idea of a drilling moratorium was unlikely to be successful, but the effort was designed to address the concerns and frustration among citizens about the dangers of gas shale drilling and the inability of the Pennsylvania government to oversee all the activity.  The more likely policy to be enacted will be a severance tax on gas production as Pennsylvania needs tax revenues.  That desire has been included in the state budget recently approved, although the severance tax needs to be written later this summer.  Steps to restrict fracturing of gas shale wells in the state because of fear over potential drinking water pollution are not likely to happen.  Politicians recognize the potential adverse impact on employment in the state and the risk of lost tax revenues from this action and have determined that it is too great a price to pay.  It is almost a given, however, that there will be increased regulation of fracturing activity, well drilling and waste water disposal, all of which will boost operator costs.  Operators probably can live with these increased costs and regulations, although it should not be seen as a given that gas prices will rise to offset the higher costs.  The operators will accept the increased regulation and costs in anticipation that the gas shale bonanza will eventually mean much higher natural gas prices.  We’re not so sure.