Bumper Crop, Paltry Prices

Lower 48 production grew by 500 million cubic feet per day in August 2009, a 0.8% jump over prior-month levels.

Farmers worry about hail, drought, insects and foreign imports. They sow their fields in springtime with hopes of abundant harvests, and lavish all their skills on their fragile, growing crops.

It’s not so different for natural gas producers. This is a commodity that comes from deep beneath the earth, yielded only after application of steel and horsepower. Gas production is an old business, and it’s cycled through periods of plenty and scarcity since its inception.

Right now, the U.S. is overflowing with natural gas, commodity prices are vexing, and production stubbornly continues to rise. Gas producers are suffering through challenging times, but better days surely lie ahead.

Domestic supply

There’s natural gas everywhere these days. The latest figures from the U.S. Energy Information Administration show that Lower 48 production grew by 500 million cubic feet per day in August 2009, a 0.8% jump over prior-month levels. Wyoming’s production was up 5.1% as gas-plant maintenance was completed and wells came back on line, while Louisiana increased 4.6% on the back of Haynesville shale drilling.

In “Other States” (a category that includes the previously mentioned areas and states outside of Texas, Oklahoma, New Mexico and the federal offshore), the EIA recorded a production gain of 2.3% as shut-in wells were brought back online and shale-gas drilling continued.

The abundance of gas means that storage pools are brimming. Maximum capacity of the nation’s storage pools is close to 3.9 trillion cubic feet (Tcf), and in early November the fields held 3.76 Tcf. Typically, the U.S. enters winter with storage in the range of 3.3 to 3.5 Tcf, so unless the winter is quite cold, the pools will still hold considerable gas in the springtime. Canada’s storage pools are also full.

Producer shut-ins and deferred completions are another confounding issue. Roughly 500 million cubic feet per day of Barnett gas is available from about 500 wells that have been drilled but not fully completed, said Sriram Vasudevan, head of Macquarie Group’s natural gas fundamentals and quantitative strategies group, in a recent roundtable. As soon as prices tick upward, operators can quickly complete these wells.

In addition to all the gas flowing from U.S. wells, imports of the commodity may also rise. Like cheap Caribbean sugar to Colorado beet farmers, liquefied natural gas (LNG) may pose threats to domestic producers.

What’s certain is that substantial LNG supplies are coming onstream around the world. Macquarie analysts forecast a significant increase in LNG this winter, as compared to a year ago. “We are expecting 1.25 billion cubic feet (Bcf) more per day of incremental LNG,” said Vasudevan.

Canadian gas is another worrisome factor for U.S. suppliers. With Maple Leaf storage full, more gas—up to 2 Bcf a day—could head south across the border.

“It’s hard to come up with a scarcity argument for North America at this time,” says Ray Deacon, senior research analyst, Pritchard Capital LLC.

Demand concerns

As robust as natural gas supplies are at present, demand has not kept pace and markets have been sluggish.

The good news is that industrial demand is struggling back from its recessionary levels. Since 2005, the nation’s demand growth has been concentrated in fertilizer, ethanol and petrochemical manufacturing, and during the past two months, natural gas use in refineries and ethanol and fertilizer plants is showing strength.

“The only way to keep production flat at 700 gas rigs would be if every well were exceptional,” says Ray Deacon, senior research analyst, Pritchard Capital LLC.

“We’re getting some recovery. At the worst, we were down 2.6 Bcf a day year-over-year, and we’ve gained back 400 million of that,” says Deacon. “The question is whether the growth can be sustained.”

Another area of concern is gas-fired power generation. Because the forward prices for natural gas have recovered somewhat, coal is likely to reassert itself in the power-generation market. During the recent period of extremely low prices—down to $2.50 per thousand cubic feet—natural gas grabbed some 2.5 Bcf a day of demand from coal. Now, with natural gas in the $5-per-thousand range, that movement will likely reverse. At that gas price, coal has an economic advantage. Macquarie’s Vasudevan estimates that in 2010, a Bcf a day of reverse switching back to coal from natural gas could take place.

Longer term, coal and other energy sources pose heavy threats as well. According to work by Pritchard analysts, some 16 gigawatts of new coal units will enter service during the coming four years, and the EIA expects 267 gigawatts of capacity generated by renewable energy sources to be added by 2020. That’s a relatively new estimate, says Deacon, and natural gas doesn’t figure to fuel any of that capacity.

Finally, like farming, sometimes it’s all about the weather. The National Weather Service’s seasonal outlook calls for a strong El Niño this winter, which should result in milder winter weather across much of the country. If that holds true, residential natural gas demand for heating will be moderate.

Better prices ahead

That will dampen natural gas prices in the short term, until the long-awaited and much-anticipated production declines finally kick in.

Most analysts have been looking hard for evidence of production declines. These are widely expected as a result of the sharply lower rig counts of the past year: the gas-rig count plummeted by more than half at one point. Inevitably, as seeds must be planted to grow crops, wells will have to be drilled to grow production.

Maximum capacity of the nation’s storage pools is close to 3.9 trillion cubic feet (Tcf), and in early November the fields held 3.76 Tcf, markedly above the five-year historical range.

And yet, the E&P industry has been able to boost gas production while operating fewer rigs in the shale plays, so the traditional straight-line relationship between rig count and production volumes is wobbly. Sharp increases in activity in the Haynesville and Marcellus shales during the past year appear to have stemmed declines from traditional reservoirs, but the essential question remains: Will production growth from the new breed of high-rate shale plays prove to be reliable?

“Nobody is missing their numbers yet, that’s for sure,” says Deacon. “With their low costs, the shales are still economic and companies continue to drill.” Operators, including such notables as Chesapeake Energy Corp., Questar Corp., Cimarex Energy Co., Cabot Oil & Gas Corp. and Southwestern Energy Co., have roundly announced higher production goals for 2010.

Nonetheless, huge declines await. “We think overall production is declining,” says Deacon.

“The only way to keep production flat at 700 gas rigs would be if every well drilled was exceptional.”

Macquarie’s Vasudevan agrees: “Our own view is that domestic supply in the winter of 2010 might be down 2 Bcf per day, versus winter of 2009.”

Too, LNG imports, another component of the surplus, could have less impact than is feared. LNG imports to the U.S. have not materialized at the levels expected. “International prices have been high, and people underestimated the degree that capacity could be run at lower rates at the new liquefaction plants,” notes Deacon.

Furthermore, the impact of Canadian gas is likely to be short-lived. Canadian rig counts have dropped so drastically that an increase in imports cannot be sustained.

“We expect we will lose a Bcf a day in Canadian imports, and we have a high degree of confidence it could be even higher than that, because field receipts in Canada are down a lot,” said Vasudevan. “We’ve lost 2 Bcf a day, and 1.5 Bcf of that is in Alberta alone, year-on-year.”

Natural gas futures held above $4 per million Btu for more than six years before sinking below that mark in March 2009. Now prices have rebounded, although stronger recovery still lies months away.

Finally, the overhang of drilled-but-not-completed wells may actually be more of a lip.

“When we compare API numbers of completed versus drilled wells, during the past three quarters producers have been completing a much higher percentage of wells,” says Deacon.

That’s likely due to an effort by many companies to tie in wells by September to maximize proved developed reserves. With the potential for borrowing-base reductions looming, companies needed new reserves on their books to offset more marginal ones that rolled off at today’s lower price decks.

The forecast? In the immediate future, gas prices will be challenged, while sturdier prices should prevail in the medium term, says Macquarie’s Vasudevan. He sees little upside in gas prices for the first half of 2010, but expects forward prices to reach $5.85 per thousand in the third quarter as excess storage is worked out of the system and the impact of lower domestic supply is felt. By fourth-quarter 2010, the firm looks for a recovery to $6.65 per thousand.

Pritchard is a bit more optimistic: “We think gas will average $6.50 per thousand next year,” says Deacon.

Like weather-wise farmers, natural gas producers will just have to be patient.