Natural gas investors are making a mistake. Natural gas and
gas-weighted E&Ps are in the media for many reasons now and
attracting capital. Unfortunately, it is too early to invest in
this sector. Sentiment may be bullish, but the math is not. Let us
look at the commodity, then at some of the equities.
Natural Gas Production
If you are invested in this sector, you already know that there
are four major issues being priced into the supply and demand
future for domestic NG (with many other minor but important
new production economics, regions, and technology
Imminent LNG Export:
Significant volumes, long timeline
Coal-fired Power Replacement:
Gradual, large, predictable
rising gas production as an oil and NGL byproduct
Nearly every demand component will grow meaningfully as far as
the eye can see. Industrial demand is further on the horizon but
will also be significant, and home heating is not going away. Even
CNG vehicles may eventually add an increment.
But here is the problem. Supply growth will smother all those
sources for a long time. Current consensus is for flat to slightly
increased domestic production in 2014. But the shale revolution is
the story of supply growth that was repeatedly underestimated.
Unfortunately, hindsight is about 20/80 in this case. Perhaps
memory is also warped. The individual rig and well productivity was
there for all to see, but there was a significant lag in aggregate
output during chapter 1 of the shale revolution. The basic story
(click to enlarge)
With the first collapse in rig counts in '09, a production
decline was expected, but it never came. The plateau was just a
head fake, and a sharp rise in output resumed. We have seen another
rig count decline in 2012, and production growth seems to have
paused again in 2013. But the problem in '09 proved to be the large
backlog of wells that were drilled but not yet producing. And we
have the same problem again, with as many as 2,000 wells in the
northeast region that are not yet producing due to a variety of
factors that are being gradually addressed.
Obviously drilling is necessary for natural gas production. But
what was a rig accomplishing in 2007, in 2010, and today? This is
the essence of the argument. For a rig count to mean something
about production, we need to know how many rigs are working and how
much gas they are developing.
We forget that the Haynesville was a world class discovery in
its day, and that in 2010 producers were proudly announcing
wells drilled in 45 days. That means that if a rig had no downtime,
it might drill as many as 8 wells per year, developing 8 x 6 =
. And it was the best opportunity for many drillers. Better than
the Barnett or the Fayetteville Shale.
But the resource opportunities and the producers have improved
in the meantime. Look at the impressive learning curve for a
producer in an old shale play. Here are the stats that Southwestern
) reports in their core play, the Fayetteville Shale:
(click to enlarge)
This is just continuous improvement in technology and
understanding in an existing formation. Progress moves much faster
in the early stages of development in a new formation. Here are the
Cabot investor presentation
slides showing their Marcellus drill times and costs, along the
annual increases in reserve estimates:
(click to enlarge)
(click to enlarge)
Compare the rig productivity from the 2010 era in the
Haynesville of about
per year to the current Cabot numbers
14 days drill time x 14.1 BCF per well =
per year per rig
This comparison isn't quite accurate because these drill times
do not include rig mobilization time, but even that is improving
substantially with pad drilling. If we considered their best drill
time of 8 days, and assumed 4 days of rig downtime, we still would
get 2.5 wells per month, or over
per year per rig. This is surely far above the average for the
play, but the rate of improvement is high for all operators.
Look at the other big names drilling in the Marcellus to confirm
these numbers. Chesapeake (
), Southwestern , Ultra (
), Range (
), Antero (Private), Seneca (
), and others. Most are not quite achieving Cabot's results, but
they are only off by percentages, not multiples.
The comparison isn't as simple as saying a rig is 8X more
productive today. But don't overcomplicate it either. Many
producers are reporting these kinds of results in the Marcellus and
the expectation of further improvements from innovations already
being field tested, and no shortage of drilling inventory and
About 28 TCF is produced in the US annually now, and if one rig
can develop as much as 400 BCF, it only requires 70 rigs to replace
our produced volume. It sounds crazy, especially considering that
the pace of
is still rapid and rigs may be achieving better results soon.
We also know that a significant amount of natural gas is
produced in association with oil, and oil production is both large
and growing in the US. It varies by basin, but it might average
15-20% across all basins, depending on how wells are classified.
With production above 7 million barrels per day now, and steadily
rising that would imply 10 to 15 BCFD or more of associated gas
production will be coming from this source in the future, a very
Natural Gas Liquids are also a valuable commodity of course, and
they must be stripped from the gas stream in processing facilities
and transported separately in most cases. MarkWest is a large
operator of these NGL plants in the Marcellus Shale. Look at this
slide from their current presentation. It looks like they see NGL
supply in the northeast growing from about
in '13 to about
(click to enlarge)
Another reason some investors find it hard to believe that
production can grow so much is the persistent myth that gas is
priced below the cost of production. The tiring axiom, "The cure
for low prices is low prices." has been repeated ad nauseum. It is
not true for LCD televisions, and it will not be true about $4
natural gas. Not for a very long time. Instead, production costs
will keep declining and high cost producers will die off.
Each producer would have you believe that everybody in the
industry is losing money (except they themselves). Consider this
next slide. It is from Ultra Petroleum's
, but you will find a hundred similar slides from other operators.
It seems to suggest that they are the lone operator that can profit
on $4 natural gas.
(click to enlarge)
Standing next to a fat person makes you look thin. UPL has done
a fine job fooling readers into accepting a very incomplete, and
very oily, peer group. Comparing Ultra Petroleum to Whiting
Petroleum (WLL) on costs per mcfe is only something you would do if
you literally did not understand the difference between oil and
gas. UPL is a dry gas producer. They should be compared with other
dry gas producers like Southwestern Energy or Cabot.
What Is Going To Happen?
Gas demand will steadily grow, but gas production will grow
faster. Producers, and investors, will initially put on a brave
face and hope that it is temporary, plan to stay the course, and
let LNG exports soon balance the market and connect US gas prices
of $4 with world prices of $8 to $18 MCF. And the faithful
investors who hold on will reap their beautiful reward. Indeed, if
it were just a question of one shoulder season back in the $2
range, I too would place that bet.
But investors should recognize:
- A prolonged price decline to the $3 mark is not priced into
E&P equities now.
- Structural oversupply could overwhelm the only elastic demand
source, coal replacement, for a long time. The only price floor
below that is the cash cost of dry gas production, below $2.
- Regional bottlenecks can drastically reduce spot prices
relative to Nymex Henry Hub. The entire northeast is now at risk
for this seasonally.
- If the Marcellus/Utica/Upper Devonian complex is really
capable of producing many times the current rate (it can!), then
even 10 BCFD of incremental demand can be met by supply increases
from these prolific formations. The holders of dry gas acreage
elsewhere, with half-cycle costs above $2, may not recover. It
isn't even certain that the Haynesville has a place in the supply
stack for a long time to come. Proximity to markets or LNG
terminals will not overcome a $1/MCF cost disadvantage.
Will gas go back below $3? It is possible, but very dependent on
weather. A much warmer than normal winter would send gas into the
basement, but we saw in 2012 that gas prices below $3 generate a
tremendous incentive for power producers to switch from coal, and
this can absorb a substantial oversupply. The facts would more
accurately support a claim that gas will have a difficult time
staying above $4, even if weather is favorable. Much of the
existing electric generation demand would be lost to coal, and $4+
prices will be attracting drilling in the most economic basins.
What Investors Can Do
Do not buy unhedged producers, dry gas producers, or remote
reserves. I think the Rockies and Northern Canada are too risky.
The transport alone could cost more than drilling. That rules out
Encana (ECA) despite their fantastically deep acreage inventory and
extensive hedges. Even the Haynesville would need to see big
efficiency improvements to be competitive. I like to pick on Ultra
Petroleum, because they are popularly viewed as a very low cost gas
producer. But they are dry, with most production in the Rockies,
and have very few hedges beyond 2013. They are the most optimistic
and vocal about an imminent gas price recovery, but they will not
likely outperform peers in any scenario.
Cabot is well positioned because it has the best Marcellus dry
gas acreage on planet earth, based on well performance to date. And
Range Resources also has great acreage, in both dry and wet areas
of the Marcellus. Southwestern also has made a good transition to
the dry Northeast Marcellus, with solid recent well results
tracking above a 16 BCF decline curve.
But the thesis here is that all the gas producers are
potentially overvalued now because the forward price strip is too
high, and the production may be so strong that even the relief
valve of LNG exports may not bring prices up until a sufficient
number of terminals are in service.
Hedging or shorting natural gas futures or futures options is
not recommended. Gas is very volatile, and subject to other
unpredictable forces, mainly weather. A cold winter can certainly
lift gas prices, even in the scenario I suggest above. I do invest
in gas futures and futures options, but cautiously and with many
years of experience. I think gas will have a very difficult time
staying above $4 throughout 2014 and perhaps longer. With
unfavorable weather, prices can quickly fall into the $2's by
Look instead downstream to the transportation and processing
(EPD, MWE) that could have pricing power as the bottleneck for many
years. Consider pipelines and utilities and gassy independent
electric power producers. Avoid coal producers, and look to other
end users that will enjoy an advantage from cheap feedstock. That
advantage will continue much longer than most believe.
If you currently own domestic gas-weighted equities, or are long
gas or the gas ETF (UNG), consider hedging or at least stress
testing your holdings against some hypothetical low prices.
Everyone knows that gas is traditionally volatile due to weather,
but a combination of bearish weather and overproduction would
require a period every bit as long and painful as 2011 when gas
broke through $2. And don't hold a losing position on the belief
that LNG exports will bring certain relief as soon as Cheniere
Energy's first liquefaction train is operational in 2015-16.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
I hold both long and short futures and futures options in Nymex
Natural Gas and adjust them frequently.
Is Inflation Of 2% Enough For You?