Natural Gas Supply Fundamentals - Natural Gas Prices Are Going Higher by 2012
I've seen many analyses claiming that natural gas prices are going higher, but I haven't seen too many arguments that address the concerns of the "new normal" of vast supply in the cheaper shale plays. This blog aims to dispel the "low natural gas prices are here to stay" belief, as I believe there are compelling reasons for natural gas prices to go up.
I believe demand side will lead to increased natural gas consumption over time to the tune of 2 to 3 percentage points per year. That is not based on heavy duty analysis and does not include the effect of potentially significant shifts to natural gas from other sources (new natural gas power plants, switching to natural gas from heating oil, etc). I'm assuming that due to population growth (leading to more households using natural gas), increase in manufacturing and/or GDP, and some other reasons, a 2 to 3 percentage point growth in demand each year is reasonable.
My original intent was to examine both the supply side and demand side fundamentals of natural gas in the US, but I am going to explore only the supply side. While the demand side fundamentals are quite important, I believe the supply side is the cause for concern among most natural gas bears and I believe it's important to address it.
Breakeven Prices Remain High in Most Gas Fields
Refer to slide 41 of the December Investor Presentation of Pioneer Natural Resources (NYSE: PXD) on the breakeven prices of different gas prices for 15% after-tax rate of return. I've reproduced the data below (be sure to check the slide anyway for the assumptions used and other info). The chart was produced by Credit Suisse as you can see on the slide.
Granite Wash – Liquids Rich Horiz.: ($0.60)
Eagle Ford Shale – Liquids Rich: ($0.20)
Marcellus Shale – SW Liquids Rich: $2.66
Cana Woodford Shale - $2.97
Marcellus Shale – SW: $3.63
Eagle Ford Shale – Dry Gas: $3.99
Horn River Basin: $4.06
Marcellus Shale – NE: $4.33
Woodford Shale – Arkoma: $4.53
Barnett Shale – Southern Liquids Rich: $4.54
Barnett Shale – Core: $4.58
Huron Shale: $4.60
Haynesville Shale – Core LA / TX: $4.85
Fayetteville Shale: $4.85
Barnett Shale: $5.21
Piceance Basin Valley: $5.55
Granite Wash – Horiz.: $5.74
Haynesville/Bossier Shale – NE TX: $6.05
Cotton Valley Horizontal: $7.43
Powder River CBM: $7.52
Cotton Valley Vertical: $7.81
After-tax rate of return is an important metric used by some companies to determine whether or not those gas assets are worth developing in the first place. If one cannot receive an appropriate return for developing gas assets, why take the risk to explore, drill, and produce gas? Credit Suisse used 15% after-tax as an acceptable rate of return in its chart. I've seen Compton Petroleum (TSE: CMT; OTC: CMZPF.PK) use 20% in its presentations. I'm sure there are other companies using this metric whether it's disclosed to the public or only used internally.
I've heard many people say that there is all this new supply due to shale gas discoveries. Because of this, natural gas prices must stay depressed. However, I posit that not all supply is the same. There are low-cost gas fields and high-cost gas fields. As you can see on the data from the Pioneer Natural Resources presentation, the cost structures the different gas fields vary wildly.
Natural gas sits around $4.40 as I write this. According to the above data, many gas fields have breakeven levels higher than $4.40 for a 15% after-tax rate of return. A good number of these gas fields even range from $5.11 to $7.81.
These breakeven economics leave companies with only high-cost gas fields in the uncomfortable situation of having to buy up lower-cost acreage, buy up (or produce from existing) oil acreage, or keep producing at a loss (or at unacceptable rates of return). I doubt all the current gas-producing companies in the US will be able to buy up acreage in the cheaper gas fields such as the Marcellus, Eagle Ford, and Woodford shale plays, so this will be an interesting dynamic to watch.
It is not uncommon for acreage once thought to be good to become useless and abandoned by the oil and gas industry for years until the economics improve. Technological advances can also make new oil and gas fields relevant again, like hydraulic fracturing has done with shale plays.
I will also note that even within each individual gas field, there are varying degrees of cost. For example, the Fayetteville shale is listed at $4.85 for a 15% after-tax rate of return. Southwestern Energy (NYSE: SWN) produces mainly from the Fayetteville shale but still routinely comes in 1st or 2nd in "low-cost gas producer" company comparison charts for having the lowest costs.
Hedges Will Roll Off
Due to the commodity boom of 2008 (and leading up to the boom), gas companies were able to obtain great hedges for future production. Hedges that were put in place during that time were for very high prices - I've seen many companies with attractive hedged production anywhere from $5.75 up to $7.00. These hedges are starting to roll off. There are some companies that still have hedges into 2013, but there are many companies whose hedges start to roll off in 2011 and 2012.
Once companies lose their rights to sell natural gas at prices much higher than the spot prices, many of them will slow down production. Without the protection of these hedges, many of these companies cannot produce a profit given that spot prices are so low.
Forward sales contracts and fixed price swaps inititated today will be a good deal higher than the $4.40 spot price for natural gas. With the majority of producers unable to produce at an acceptable rate of return at $4.40, I can't imagine companies would agree to future production at prices lower than $4.50 - that price is likely to be at least $5.00 to $5.50 per mcf.
Emphasizing Oil, De-emphasizing Gas
Higher oil means higher gas prices. Not all oil and gas companies produce 100% gas or 100% oil. In fact, most of them produce some combination of the two. Refer back to the acceptable rates of return for gas: at $4.40 per mcf, not many gas companies are making much money (without hedges). With oil at $90, it makes a lot more sense for companies with oil acreage to drill for oil until gas goes a lot higher.
Companies that produce both oil and gas are shifting to oil/gas splits that result in less gas and more oil. Gas is being de-emphasized due to the lack of acceptable profits. I've yet to see a single company ramp up gas as a percent of total product mix, while I've seen PLENTY of companies ramp up oil as a percent of total product mix. This will definitely lead to lower gas production in 2011 and beyond compared to 2010. Less gas produced means lowered gas supply - this means there will be upward pressure on the price of gas as the supply shrinks.
Land Leases and Sunk Costs
In order for companies to "own" acreage in the oil and gas space, they must either purchase or lease mineral rights. Since oil and gas are not always found on acquired land, it is often leased and not purchased. Read here for a good piece on mineral rights. Anyway, the leases don't last forever, so the land must be developed before the lease expirations or the company loses the acreage.
Many companies have land leases expiring in 2012 or sooner on their acreage. In order to keep their land rights, they must develop their land (i.e. drill wells). My guess is these companies have a lot of sunk costs (buying up land leases, performing 2D and 3D seismic surveys, etc) and they don't want to pony up those costs again starting from scratch on future acreage. For example, if a gas field has a cost structure of $5.50 per mcf (not a good cost structure) but you've already sunk $2.00 per mcf into the development process, why wouldn't you continue to develop the land at $3.50 per mcf? The $2.00 per mcf is already gone forever, so it doesn't factor into the decision.
Even if the revenue associated with these gas fields is net income negative due to large non-cash depreciation/amortization charges (there go those sunk costs again), it makes sense to develop the fields if they will produce positive future cash flow after discounting the sunk costs.
Once the land lease expirations have passed, one of two things will have happened: (1) companies will either have drilled their wells in order to keep control of their acreage or (2) they will have allowed their land leases to elapse before being able to drill. Either way, the passage of 2012 will mean less drilling on these particular gas fields. Less drilling means fewer wells, which ultimately means less gas supply from these wells. Keep in mind that not all gas acreage with sunk costs will be developed due to constraints such as the finite supply of drilling rigs. I fully expect the leases on some land to expire despite the sunk costs on them, which is very unfortunate for these companies.
Note: I used 2012 as the "doomsday" because I've seen this number bandied about regularly in various natural gas articles. Anecdotal evidence suggests 2011 will have its fair share of land lease expirations. All told, I'm looking for land lease expirations to be a smaller concern by 2013, with a good chunk expiring in 2011 and 2012.
The natural gas supply picture is ugly, but I believe it will clear up in the next 2 years. The supply side picture looks ugly right now, with so much new supply in the shale plays. I can see why it would seem to some that low natural gas prices are here to stay. However, I believe I have provided several plausible arguments for natural gas supply to reduce in the near future (leading to higher prices).
I will admit that the new gas discoveries have probably shifted the breakeven price of the entire industry down a bit, but I'm arguing that gas prices can recover from the current cloud of negative sentiment.
If I wanted to invest in natural gas companies, I would look for companies with at least one of these two attributes: (1) the company is a low-cost producer or (2) the company has oil assets. Low-cost producers can continue to produce profitably and buy up acreage from distressed gas companies at a discount. Companies with oil acreage can do the same thing - make money on oil while gas prices are depressed and opportunistically snatch up attractively priced acreage while biding their time.
Even though I believe gas prices are headed up, low-cost producers and owners of oil acreage provide an extra layer of protection from the unknowns of tomorrow - there's nothing like an extra margin of safety to help you when things don't go exactly as planned.