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Natural Gas Supply Fundamentals - Natural Gas Prices Are Going Higher by 2012

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January 14, 2011 – Comments (47) | RELATED TICKERS: CHK , DVN , SWN

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
Pinedale: $3.96
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. 

What Now?

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. 

47 Comments – Post Your Own

#1) On January 14, 2011 at 3:59 PM, portefeuille (99.59) wrote:

If natural gas prices in the U.S. go up considerably you may have to consider non-U.S. supply (entering via LNG for example) as well ...

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#2) On January 14, 2011 at 4:01 PM, portefeuille (99.59) wrote:

#1 or via pipeline Siberia -> Alaska -> Canada -> ...

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#3) On January 14, 2011 at 4:05 PM, TMFBabo (100.00) wrote:

@portefeuille: Thanks for the comments so far.  I'm not calling for substantially higher prices - I think $5.00 is a more appropriate price than the sub-$4 range we saw for a while.  I know it's up to $4.40 on spot markets now, but that's probably due to the seasonal effects (ie. Winter).

Note: By the way, I'm actually rather new to oil and gas, so feel free to refute my arguments, add something I haven't considered before, etc. 

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#4) On January 14, 2011 at 4:54 PM, rfaramir (29.32) wrote:

With the evidence you show, it looks like NG price can rise some, and on a very macro level, inflation of the money supply will be good for rising commodity prices, but with all those fields in the 5-8 range, as prices rise, supply will resume again, keeping the rise modest.

What I want to see is new uses for NG. Where's all the new clean NG power plants that wind farms need to be paired with (for when the wind stops blowing)? Where are the NG conversions for automobiles? Where are the GasToLiquids plants, to make gasoline from all the cheap NG? (There may be one coming in Canada, but that's the only one I've heard of.)

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#5) On January 14, 2011 at 5:34 PM, RRobertsmith (< 20) wrote:

TBoone vs TMFBabo this should be good...TBoone is long CHK

break out the popcorn

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#6) On January 14, 2011 at 5:41 PM, TheFoolishEdge (22.44) wrote:

Good post, I enjoyed reading it and your analysis is strong.  I disagree with a few of the outcomes because I think that LNG imports will soar if prices start to rise.  Currently, Qatar has several tankers that are just hanging out and waiting for a destination. Also, Natural Gas reserves tend to be located in states that will have a lower tax burden in the next couple of years. 

Again, good post.

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#7) On January 14, 2011 at 5:43 PM, Pennyperson (< 20) wrote:

Very interesting article. I do believe it’s wise for a company to play NG & Oil, but I don’t think it’s necessary for their survival. Take for instants SFY. They made an all out bet on NG with depressed prices in 09. It must have paid off because their stock price has since doubled. Read here:

http://10qdetective.blogspot.com/2009/08/how-lucrative-eagle-ford-shale-gas-play.html

 

I do agree that land leases are set to expire for some of these companies.  And is the reason I like the move by GST to recently acquire up to 80,000 acres in the Marcellus Shale.

I need to read this again when I have more time.

Rec+

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#8) On January 14, 2011 at 6:30 PM, TheDumbMoney (42.81) wrote:

I don't know much about natural gas, but it seems we have so much supply in the U.S., by which I mean potentiality that could be brought online if prices rise.  Given that, and second, given the costs of liquifying, transporting, and regasifying natural gas, I cautiously disagree with those commenting who say "gas price rises will just lead to more LNG imports" to the U.S.  That could be true I suppose, but it just seems to me that that is only true if the costs of producing the gas elsewhere are inherently lower than production costs here, and are inherently lower by an amount that is greater than the cost of liquifying, transporting (most likely by ship, at least initially), and regasifying that foreign natural gas to get it here.  I don't know the answer to this, but I'm curious to know if anyone does, since it's a topic I've grown interested in.  Either way, it seems like there is good evidence here in this post and elsewhere that natural gas should rise moderately from here, but that absent some techtonic shift (e.g., widespread adoption in personal automobiles, etc.) it's not going to shoot up anytime soon, no?.

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#9) On January 14, 2011 at 6:47 PM, TMFBabo (100.00) wrote:

As always, I appreciate the comments and am happy with the quality of the comments. 

@portefeuille: Interesting note on the pipeline.  I'd be interested to find out what it would cost in royalties/fees to use that set of pipelines to transport the LNG. 

@rfaramir: I would love to see us use more natural gas too.  I personally don't see oil falling very far below $70, so natural gas is much more attractive on an energy-equivalent basis even at much higher natural gas prices.  With so many different people pushing different types of energy, who knows what the future will hold? I do know that it's reasonable to assume a 2 to 3 percentage point increase though, so that's all I'm willing to assume. 

Good point on the higher gas fields providing a price ceiling.  There's also the LNG factor as mentioned by portefeuille and TheFoolishEdge.  I'm given to believe Canada's gas fields are a bit more expensive than the ones in the US, but there's another source of supply if prices get high enough. 

@RRobertsmith: I'm on TBoone's team - I own CHK.  I'm happy about Icahn's stake too, by the way.

@TheFoolishEdge: Thanks.  The LNG point is a very important one.  My guess is that in the end, the bulls are too optimistic and the bears are too pessimistic about the price level.  I'm sure it'll settle somewhere reasonable, but I don't know where that will be.  I do think $5 per mcf is a reasonable level, unless that's above the point where the LNG imports shoot up.  If it is, then a lot of US gas producers are pretty screwed going forward. 

Do you have any insights on the price at which other countries would benefit from exporting their LNG to the US? The countries in question would have to have much lower breakevens than the companies operating in the US (which they might have - I don't know).

@Pennyperson: You and I aren't in disagreement.  Eagle Ford acreage is pretty awesome, low-cost acreage.  SFY's Eagle Ford acreage counts as low-cost in my book, which fits my low-cost criterion. 

@dumberthanafool: It's interesting that I tried to talk about US gas supply, yet there are a lot of other factors at play - not to mention potential supply from other countries.  As I've typed out every reply one by one, I've settled on the stance that while imports would rise in the face of higher gas, the costs associated with having to liquify, transport, and regasify are probably high enough that it won't happen on a large scale till at least $5.00 or $5.50 per mcf gas (which is all I'm calling for).  It might even be a much higher price - who knows? (I'm curious to know just as you are)

Maybe $5.50 per mcf is asking too much (I still don't think so), but I think $5.00 per mcf is very reasonable given the breakeven economics of the US producers.  I'm given to understand Canadian producers have higher breakeven economics (even if only a little), so I don't think the Canadian import possibility will affect the price until it's higher than it is now. 

You're right about the "anytime soon" part - I think the price will finally get to more reasonable levels sometime between now and the end of 2012, which is a very long time period. 

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#10) On January 14, 2011 at 7:03 PM, tekennedy (68.04) wrote:

Very well thought out discussion and good links.  This is a sector I've been interested in and this gave me some good info.  The other thing which will impact pricing is new drilling and its costs.  I've got the impression that there are large areas which are just beginning to be drilled which will likely add low cost wells in the future.  Those companies don't care what other companies have for production costs, they only care what they can sell it for.  It'd be nice if those costs were predictable...

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#11) On January 14, 2011 at 7:20 PM, Pennyperson (< 20) wrote:

tekennedy

Why I still hold PDS & full D I own the stock.

Check out their drilling rigs (some of the best in the Biz) and they are here in the U.S drilling and will hold the stock even though I recently thought of hitting the sell button. They even helped the Chilean miners rescue.

http://www.canada.com/news/Canada+Precision+Drilling+helps+Chilean+miners+rescue/3502451/story.html

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#12) On January 14, 2011 at 7:31 PM, Pennyperson (< 20) wrote:

OT

BTW - if anyone can figure out my other to call names here on the Fool - I'll give you an A+

Shouldn't be to hard figure out given the other two are into natty gas and oil plays too. =)

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#13) On January 14, 2011 at 9:04 PM, portefeuille (99.59) wrote:

Qatari gas to reduce Russian dominance

Europe Seeks Record Spike in LNG Imports in Nov. (22,441 -> 22.441 for U.S. readers ...)

Qatar to Export More LNG to China, India

LNG Export Income Triples in Five Years (Qatar)

Qatar set to boost India LNG sales

 

OIL INDUSTRY CONVERSIONS

How to Measure Natural Gas

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#14) On January 14, 2011 at 9:14 PM, Earendil (< 20) wrote:

Here’s some of the data you were looking for on LNG import costs and prices (Data 1 year old – Dec 2009 – from Utilipoint International).

1. The USA has regasification capacity of 9.4 Bcfd, but only 1 Bcfd left those facilities in 2008 and peak was 3.2 Bcfd in 2007.

2.  Pretty much the only LNG coming in to the USA in 2009 was from 2 long term contracts (one 40 year agreement starting in 1971, one 17 year contract starting in 2002), neither of which reflect current Nat Gas market economics 

3.  The USA could bring in up to 9.4 Bcfd LNG per year (about 18% of US Nat Gas demand?) before needing to invest in more regasification capacity. 

4.  The reason that LNG is not imported into the USA is economic.  First, there are other markets that will pay higher prices.  LNG landed in Japan (before regasification and distribution) sold for $6/MMbtu in 2009.  LNG landed in Europe sold for $4/MMbtu.  Terminals in the USA were only willing to pay $3/MMbtu.  This is because new discoveries of Nat Gas in USA were holding price (at hub – ie. Compared to LNG, after regasification and some distribution) at about $4/MMbtu in 2009. 

HYPOTHESIS:  LNG will not be attracted to flow into the USA in significant quantities until the Hub price of US Nat Gas rises to $5-$6/MMbtu or higher.

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#15) On January 14, 2011 at 9:17 PM, portefeuille (99.59) wrote:

Worldwide LNG Facilities (pdf, from here)

 

I even have a "stock recommendation" for LNG, hehe. Linde (LIN:GY). There are currently 160 LIN:GY shares in my "fund" (see here) with break-even of around 104.88 EUR.

LIN:GY in Frankfurt trading.



enlarge

 



enlarge

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#16) On January 14, 2011 at 9:27 PM, portefeuille (99.59) wrote:



enlarge

(from here (ppt))

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#17) On January 14, 2011 at 9:40 PM, portefeuille (99.59) wrote:



enlarge

mt -> million tons per annum

from here.

The role of LNG in a global gas market (pdf)

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#18) On January 14, 2011 at 9:47 PM, portefeuille (99.59) wrote:

#17 http://www.santos.com/conversion-calculator.aspx

 

-> 460 mt LNG = 4.6 * 10^8 t LNG <->  0.213 * 10^8 MMcf = 2.13 * 10^5 Bcf. So around 200000 Bcf of natural gas to be shipped around per year in around 10 years ...

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#19) On January 14, 2011 at 9:53 PM, portefeuille (99.59) wrote:

2 * 10^5 Bcf -> 2 * 10^11 Mcf * $5/Mcf = $10^12 = $ 1 trillion.

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#20) On January 14, 2011 at 10:05 PM, portefeuille (99.59) wrote:

mt -> million tons per annum

mt -> million metric tons (= tonnes) per annum

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#21) On January 14, 2011 at 10:06 PM, Ticker007 (20.34) wrote:

Lets go shopping # 18 and 19.....SPAM

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#22) On January 14, 2011 at 10:47 PM, gman444 (28.80) wrote:

Great post with a lot of really useful information.  Here is another perspective on LNG:

http://seekingalpha.com/article/242898-what-if-the-u-s-became-a-net-exporter-of-liquefied-natural-gas?sourcee=yahoo

The author makes a pretty good case for why the US is moving toward becoming an exporter of LNG.

As for natgas in general, even if the oversupply and price stagnation continue for awhile, it has so many advantages over oil-based fuels (cheaper, cleaner, and most importantly, domestic) it seems almost inevitable that it will become the preferred energy source of the future.  Maybe the oversupply makes it even more so. Major oil producers are scrambling to increase their natgas exposure, and major players are putting big money into natgas stocks and projects.  There has been a big runup in natgas stocks while the price of natgas has remained low--smart money seems to be betting that these stocks will go up even more when the price of natgas finally goes up and stays up.

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#23) On January 14, 2011 at 10:51 PM, portefeuille (99.59) wrote:

#15 http://caps.fool.com/Ticker/LNEGY.PK.aspx.

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#24) On January 14, 2011 at 11:14 PM, portefeuille (99.59) wrote:

------------

Asian Spot LNG Prices Rise on Winter Demand

Posted on Jan 14th, 2011

Asian spot LNG prices crept up to $10/MMBtu Friday as severe weather underpinned further demand across North Asia. Platts February Japan Korea Marker climbed from $9.75/MMBtu at the start of the week to a high of $10.025/MMBtu Friday.

Temperatures in Japan, South Korea and northern China have dropped in the past few weeks, lifting LNG demand. Seoul has seen temperatures fall to as low as minus 16 degrees Celsius this week.

...

------------

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#25) On January 15, 2011 at 12:41 AM, ajm101 (31.95) wrote:

I think US LNG exports would have trouble being economical compared to Qatari gas, which has kept me waiting for a pullback.  And non-lng wouldn't work, as Canada and Mexico are net producers.  The best thing for natural gas prices would be electrical or transportation use, replacing coal or oil, respectively.  I was going to post a follow up on my last nat. gas post (work has been too busy to do so), but after some research I was surprised how cheap natural gas power plants were compared to cleaner coal and nuclear.

That chart of production prices to achieve reasonable returns was incredibly useful, thanks.

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#26) On January 15, 2011 at 12:41 AM, Pennyperson (< 20) wrote:

Babo

Sleep tight...wars will be fought over oil  - watch and see shamelessly....if we live that long. 

NG is the future, along with wind & solar.. etc.

My hope is for (all) the children of this world..may we all come together some how....some how.

But, that may only live in my dreams.

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#27) On January 15, 2011 at 2:46 AM, Valyooo (99.40) wrote:

Babo,

If you expect a turnaround in prices, wouldn't you rather a high cost producer than a low cost one?  That gives you more leverage.

If for instance, it costs them 4.50 to produce, and the price is currently 4.75 (its not but an example) and the price bumps up to 5 bucks, their profit just increased 100%, whereas if costs were only $2.50, that increase would only lead to an 11% increase in profits.

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#28) On January 15, 2011 at 2:37 PM, Valyooo (99.40) wrote:

I think it was JakilaTheHun who said "when spot price is less than production costs, there are opportunities for profit to be made" or something to that extent.  Could have been checklist.

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#29) On January 17, 2011 at 8:06 PM, jlanganki (< 20) wrote:

A safer way to play natural gas is to buy a stock whose profits are largely driven by the price of natural gas: independent power producers.  NRG, Exelon, and Calpine are some good ones.  Natural gas prices tend to drive the profits of these producers and you don't deal with the risks of exploration and development.  Another thing driving the price of natural as is the price per BTU.  Natural gas would have to reach a price of about $15 to reach a BTU to BTU parity with a barrel of oil.  However, a lower target of $12 would bring it inline with it's historic ratio against the price of a barrel of oil.  Either way, you're looking at the current price more than doubling this decade.

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#30) On January 17, 2011 at 8:11 PM, jlanganki (< 20) wrote:

The price of coal is also rising.  At a certain point, it becomes cheaper to generate electricity with an efficient natural gas generator than a coal generator.  There are some inefficient coal generators that are already offline because the cost to run them is too high.  There was a big investment in efficient natural gas producing power plants last decade so these will begin to have a cost advantage (and therefore drive demand much higher) if coal prices are driven higher.

All energy supplies are related in some way.  It doesn't make sense for some sources of energy (oil) to skyrocket while other sources (natural gas) are plumetting.  Supply and demand issues will resolve themselves under normal market force conditions.

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#31) On January 18, 2011 at 9:10 PM, jordandrahota1 (30.39) wrote:

Very well put and I agree 100%

 On a side note - Thank you very much for giving me an invitation to blog - it means a lot

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#32) On January 19, 2011 at 2:03 AM, TMFBabo (100.00) wrote:

Thanks for the comments, everyone - part of what I like about blogging is that I expect comments that bring up things I haven't mentioned and hopefully teach me a few things. I appreciate all the extra information and links you all provided.  

For the demand side in general, I didn't consider long-term things such as natural gas power plants and such because I was looking more short-term in my analysis and building a power plant or switching to alternative sources of energy take years and I purposely didn't look that far out.  I was arguing more that the price will be higher even just 2 years out due to certain forces at work on the supply side.

Due to the cost of delivery, and the low cost nature of enough gas fields here in the US, I currently believe the potential imports of LNG would not occur until the price is much higher than what I'm calling for ($5.00 to $5.50 by the end of 2012). The cost structures across the globe and the cost of transportation (fees for pipeline usage) are things I will delve into in the future.

@Valyooo: It depends how high a turnaround you expect.  If the price only goes to $5.50 within a few years, that might not be enough - doubling or tripling minuscule profits might still end in minuscule profits.  Also, some companies might be going from losing money to barely making money.

High-cost producers are definitely good if you expect the price to go parabolic even for a month or two, but I'm not very certain that's going to happen.  I am pretty convinced, though, that I'll see at least $5 within 2 years.

Moreover, what if the unforeseen occurs and commodities crash? Low-cost producers stand a chance of making money and acquiring more and more acreage while high-cost producers might lose their shirts and sell acreage at a discount to low-cost producers, dilute shareholders, or other terrible things.

You can probably make more money much of the time by seeking more profits, but you'll be burned badly once in a while due to the increased risk of going for strategies such as high-cost producers.  As my investment strategy has involved, I've found that one can actually do quite well without always seeking the highest profits.  

The issue here is leverage vs. no leverage.  Some companies employ enough debt in their capital structure such that small increases in the underlying commodity will end up in the highest benefit to the bottom line.  

Returning to my earlier point, I'm not saying one should blindly buy up low-cost producers or other producers with a good oil/gas mix.  Within those categories, there are undervalued and overvalued companies, of course.  I'd try to pick from the ones with the largest discounts to proved reserves that also have huge unrisked developmental potential to go with the discount to reserves. 

If you trade at a discount to reserves compared to other producers with similar cost structures, I argue you should revalue compared to your peers (trade at the same percent discount to reserves as peers). 

For example, if two producers both produce at a $4.00 per mcf breakeven but one trades at 50% discount to reserves and another at 20% discount, I'm arguing the guy at a 50% discount should go up until it trades at a 20% discount, all other things equal (debt, developmental portfolio, pipelines owned/operated, etc). 

"All other things" will rarely be equal, so you must exercise judgment in determining which one is "better" - I think a good investor can make such determinations.

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#33) On January 19, 2011 at 3:34 PM, TMFBabo (100.00) wrote:

As my investment strategy has involved, I've found that one can actually do quite well without always seeking the highest profits.  

Evolved, not involved.

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#34) On January 20, 2011 at 12:32 PM, GoldenEggs (78.61) wrote:

Thanks everyone for this whole thread, and thanks chartefeuille for all of your links!

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#35) On January 22, 2011 at 5:39 PM, jlanganki (< 20) wrote:

Just a clarification on power plants:  there is no need to build new natural gas power plants to drive demand higher for natural gas.  There are huge numbers of "peaking" power plants already built which are only used during peak air-conditioning season in the middle of summer.  The price dynamics can shift quickly and make these natural gas-burning plants profitable to run during non-peak times.  At any given time the cheapest form of electricity-producing generators will be running.  If natural gas were cheaper to use than coal then coal plants would shut down and natural gas plants would be fired up.  This creates a "price floor" because the cheapest form of energy between coal and natural gas will always be used.  Prices can also run ahead of actual demand as the market realizes the discrepancies.

I just want to point out that demand can shift rapidly (within a 2 year time frame that you are looking at).

 $5.50 sounds very conservative due to potential supply and demand changes.  I really think $7.50 is likely in the next couple years.  And long-term we're looking at $12.00 (within the decade).

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#36) On January 26, 2011 at 3:34 PM, DPSIII (46.28) wrote:

Nice analysis. The chink in the armor is the belief that there is still some interrelation between oil and gas prices. They have effectively become delinked.

 I think we also must consider regulatory constraints to development of shale plays. If New York opens up access to the Marcellus, that's even more downward pressure.

I've been surprised to see the lack of momentum for conversion of existing LNG terminal facilities to export-import terminals. But liquefaction requires extensive/expensive facilities.

I think you can't really try to forecast the future of supply without considering these issues, as well as the need for investor owned utilities and mechant generators to focus capex on combined cycle plants for baseload since permitting for coal is a non-starter, there will be many baseload generation retirements in coming years, undeveloped hydro resources are few and far between, $10B per nuke plant doesn't jive with current capital markets, and renewables don't have a workable storage solution on the horizon (even compressed air storage would usually use natural gas engines).  That said, the supply is proven at this point, and unless the U.S. gets in the export game...well, then you are counting on a demand spike for generation and heating from economic recovery, sustained hot summers and cold winters.

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#37) On January 26, 2011 at 3:35 PM, DPSIII (46.28) wrote:

Nice analysis. The chink in the armor is the belief that there is still some interrelation between oil and gas prices. They have effectively become delinked.

 I think we also must consider regulatory constraints to development of shale plays. If New York opens up access to the Marcellus, that's even more downward pressure.

I've been surprised to see the lack of momentum for conversion of existing LNG terminal facilities to export-import terminals. But liquefaction requires extensive/expensive facilities.

I think you can't really try to forecast the future of supply without considering these issues, as well as the need for investor owned utilities and mechant generators to focus capex on combined cycle plants for baseload since permitting for coal is a non-starter, there will be many baseload generation retirements in coming years, undeveloped hydro resources are few and far between, $10B per nuke plant doesn't jive with current capital markets, and renewables don't have a workable storage solution on the horizon (even compressed air storage would usually use natural gas engines).  That said, the supply is proven at this point, and unless the U.S. gets in the export game...well, then you are counting on a demand spike for generation and heating from economic recovery, sustained hot summers and cold winters.

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#38) On February 11, 2011 at 8:43 PM, GenericInvestor (85.87) wrote:

are you still behind compton? i saw your blog on it but haven't heard anything about it since then.

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#39) On February 12, 2011 at 6:20 PM, TMFBabo (100.00) wrote:

@GenericInvestor: I sold Compton to buy DBLE in December when I sold out of a lot of positions to take a comically large position in DBLE.  I still like Compton's reward-to-risk and it's very much still on my radar, but I don't hold a position right now.  That may change if every oil and gas stock keeps going up and Compton stays under $0.50...

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#40) On February 12, 2011 at 6:36 PM, sfhowfegrg (< 20) wrote:


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#41) On February 13, 2011 at 12:15 AM, Lordrobot (92.40) wrote:

Balderdash! The present price of gas has dropped 20% since this article was written. Granted I get to play Monday morning QB so my job is a lot easier. So let me list why gas has not gone up.

1) way too much production from every source.

2) Stupid US energy policy that excludes NG and Coal in favor of tax credits for stupid things like ethanol where each gallon produces an oil deficit of 70,000 BTUs.

3) New fractionating techniques keep improving. So production from rock formations is sky high and getting higher.

4) There has been no shutdown of older high cost gas fields because the producers are scared that the new production will cost less so they want to get what they can.

5) The futures market is in a contango with a surplus so large the potential for oil to rise is highly unlikely unless you are playing the swing trade off a dip. But that is just chump change.

6) NG and LNG is impractical for vehicles. It will never fly. We will have electric vehicles before NG catches on.

7) the wrong analogy: Gold is to silver as Oil is to ..... Gas? Heavens no! They are now totally disconnected from each other.

8) Of all the global producers of Natural Gas, we have plenty but the world has much more.

In sum, why waste time in a Contango trying to hope it chumps higher. There is no compelling reason for it to go higher. Demand is not up, winter is coming to a close, and every day the inventories build with no drop off in production.

I will also add that oil inventories rose substantially during Jan and continue in Feb so the oil patch is not a demand situation but a speculative bubble in the midst of rising inventories. That is a formula for oil to drop and with it will go NG.

I find nothing compelling in the natural gas space in the present and most certainly not in the future. NG is a dead animal. 

 

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#42) On February 13, 2011 at 1:56 AM, TMFBabo (100.00) wrote:

Just a note in general:

I wanted to give an in-depth analysis of supply and demand fundamentals for natural gas, and what I ended up posting was a tiny sliver of the supply picture and nothing on the demand picture.  With the other things I have on my list of things to research, I thought it was unwise to spend tens of hours learning and posting everything about natural gas in order to post everything I originally wanted when I had enough other things on my plate that were more important at the time.

I'm glad I posted my incomplete post anyway, because I believe the comments section provided very nice insights from the CAPS community (as usual) and I learned a good deal.  

I want to clarify on the delinking of oil and gas: I was very careful not to mention the oil and gas ratio, because I do not currently believe oil and gas move in lockstep.  Further, I believe oil deserves to trade at a premium.  

My argument is that many companies have both oil and gas acreage and capital flows to the projects with highest rates of return.  With gas so low, capital will flow to oil projects, not gas projects. If you can't make money on gas and you can on oil, you're going to extract the oil first. 

I believe oil will stay above $70 longer term, so I believe companies will (continue to) de-emphasize natural gas if it stays at this level.  Chesapeake has stated in many presentations that it will be increasing oil production and decreasing gas production for as long as gas remains below $6.00 per mcf.  

Companies with just oil or just gas will not care about what I just said, but there are a lot of companies that do indeed have both types of acreage.

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#43) On February 13, 2011 at 2:01 AM, TMFBabo (100.00) wrote:

@Lordrobot: You raise a lot of great points.  I hope I've clarified my line of reasoning on the oil and gas relationship aspect, which is but one of your many points.  

The only other comment I have here is that I was making a more intermediate term call.  I wish I included "end of 2012" in my title instead of just "2012" because I meant that I thought gas would move higher within 2 years.  

I fully acknowledge that gas prices have moved from below $4 to as high as mid $4 because of the Winter and that prices would probably move below $4 again afterwards.  I did not mean that gas prices would immediately go up after my post and really thought it would take 2 years for all this to happen, not just a few weeks or even months.  Maybe they take longer to go up and maybe they never do. 

I avoid making short-term predictions because I expect to be no better than a coin flip.  

Anyway, it is entirely possible that I'm completely and utterly wrong as many people believe.  I still think it's worth getting feedback on my thoughts so that I can learn from them.  

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#44) On February 14, 2011 at 4:33 PM, GenericInvestor (85.87) wrote:

"@GenericInvestor: I sold Compton to buy DBLE in December when I sold out of a lot of positions to take a comically large position in DBLE.  I still like Compton's reward-to-risk and it's very much still on my radar, but I don't hold a position right now."

Oh I see, pump it and dump it.

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#45) On February 14, 2011 at 5:11 PM, TMFBabo (100.00) wrote:

Oh I see, pump it and dump it.

Yes, if by "pump and dump" you mean sell at a loss.  

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#46) On February 15, 2011 at 6:01 PM, GenericInvestor (85.87) wrote:

Yes because you had a crazy blog about buying it but didn't even mention it when you sold it.

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#47) On February 15, 2011 at 6:55 PM, TMFBabo (100.00) wrote:

GenericInvestor, you need to get your facts straight.  I never wrote a blog about Compton Petroleum.  EV38 did (link here).  To come in here and accuse me of pumping it and dumping it through my blog when I never wrote such a thing is extremely rude. 

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