As oil prices descended into the $50s, then the $40s in December, I knew that they had overshot any sort of sustainable level. Careful research showed me that oil needed to average at least $65 a barrel to sustain current supply levels, and needed to be closer to $100 to ensure production capacity five years or more into the future.

The price of oil had simply rendered too much production uneconomical, guaranteeing that supply would be quickly constrained when demand picked up again. When that happened, I anticipated that prices would once again spike. I believed that the steep contango of the oil futures curve, pricing oil for delivery in future months at a high premium over the near term, was confirmation that prices would soon begin to move up again.

I suggested that investors should begin to slowly accumulate long positions in oil up through early March (see “The Sleeping Threat of Low Oil Prices“). Those who did were lucky enough to even pick some up in the $30s in February.

My patience was rewarded as prices rebounded to around $55 by the end of the month. That was probably too much, too fast, so it was no surprise to me to see it pull back to the $50 range this week. Again, I view this as a golden opportunity to add a little more to my positions.

The Gas Air Pocket Sets Up

Now I am seeing the same pattern in natural gas (or as traders sometimes call it, “natty”), only the danger of constrained supply is possibly even greater, since about 84% of US natural gas consumed is produced domestically and there is very little storage throughout the system.

Gas prices have plunged 72% from their record of over $13 per Mcf¹ to $3.75 on Monday, taking it all the way back to 2002 pricing. (The spot price for natural gas has only fallen below $4 once since 2002, in September 2006.)

Figure 1 NYMEX Henry Hub prices, 2-year chart
Source: Trading Charts

As with oil, the collapse in prices has forced many drillers, especially marginal producers, to lay down their rigs. According to data from Baker Hughes, natural gas exploration rigs in the United States have fallen steadily from a record 1,606 in September to 884 as of March 13, a more than 45% decline in active rigs.

Theresa Gusman, head of equity research for Deutsche Bank AG’s DB Advisors unit, has estimated that spending on U.S. exploration and production will drop 40% to $22.5 billion this year.

According to a Bloomberg report, the sharp cutback in drilling could produce as much as a 5% loss in gas production in the fourth quarter of this year, even more than the decline projected by the Department of Energy.

Costs Are Key

Beyond the general decline in drilling, there is another factor that augurs higher prices. Nearly all of the increase in domestic natural gas production we have enjoyed for the last several years has come from the unconventional shale plays we have frequently discussed in these pages, like the Barnett, Haynesville, and Marcellus formations.

Unfortunately, unconventional shale gas is more expensive to produce than conventional gas, and only a small fraction of the potential makes economic sense when gas is selling for $3.75 per Mcf. According to global energy advisory firm Tristone Capital Inc., the average cost of production in the top nine North American shale plays is around $4.50 per Mcf.

Yet there are some producers who can still make a profit at these levels. For example, Atlas Energy reports its drilling costs in the Marcellus Shale—the most profitable of the shale plays, in New York and Pennsylvania—as running $1.49 per Mcf, so drilling continues there, albeit at a slower pace. The Haynesville formation is still profitable as well, but drilling in the Barnett and Fayetteville formations has all but stopped, as the cost of production there is too high. Barnett producers claim they need gas back in the $6-8 range before they’ll resume drilling.

This chart of the production cost for major US natural gas producers tells the story plainly:

Figure 2 Natural gas production costs of major US producers
Chart by Chris Nelder. Sum of lifting cost and finding and development data from Southwestern Energy Company SEC Filing, attributed to John S. Herold database, “All data as of December 31, 2005, 2006 and 2007.” “Drillbit F&D Cost per Mcfe defined as three-year sum of total costs incurred less the three-year sum of proved acquisitions cost divided by the three-year sum of reserve additions from extensions and discoveries.”

At under $4 per Mcf, only about half the producers can break even, let alone show a decent profit.

As the chart shows, Chesapeake Energy Corp., the largest independent natural gas producer in the nation, is suffering for the higher cost of its production. The company has slashed its conventional drilling by 75% over the last six months, and expects to increase its cuts to 85% in the next 60 days. Speaking at an energy conference last week, CEO Aubrey McClendon said, “You simply cannot make money in a sub-$7-and-$8 environment.”

Presumably by “you” he doesn’t mean ultra-low cost Ultra Petroleum Corp. (NYSE: UPL), or Southwestern (NYSE: SWN), which remains one of my personal favorites as a “pure play” on gas.

In sum, what we’re seeing is the destruction of the marginal supply that gave us this surplus. We’re cutting back to the bone, and the longer it takes for prices to rise again, the less slack there will be, and the sharper the curve of the price spike. Like oil, we’re setting up an air pocket in the fuel line, which we’ll hit the minute we step on the gas.

Larry Nichols, chief executive officer of natural gas producer Devon Energy Corp. (NYSE: DVN), also sees the air pocket forming. “When the recession ends and the economy starts booming, we’re going to have less natural gas than we do today and prices are going to spike back up,” he said two weeks ago. “The drop in supply will be so steep, it could easily catch up to where demand has dropped to before the recession ends.”

Supply Nearly Back in Balance

The obvious questions now are: Why is the price of gas so low, and when will it pick up again?

Gas prices are dragging the bottom in part due to an abnormally warm winter in the Northeast, but mostly due to the recession.

Gas consumption in the US is split roughly in thirds between commercial and residential demand (which is fairly constant), electricity demand (which grows at about 5% each year) and industrial demand. It’s the latter category which has dropped off sharply in the economic downturn, and which has been most responsible for gas demand destruction. According to the Department of Energy, industrial demand declined 5 percent in the fourth quarter of 2008 from a year earlier, or about 1 Bcf/d (billion cubic feet per day).

As one may expect, this has produced a temporary glut in supply. But if you look at the historical chart of the relationship between gas supply and price, you see that inventory levels generally presage price moves. At this point, we’re heading into a slight deficit, and if it continues down under the combined pressure of reduced drilling and increasing demand, we should see the next spike in gas prices.

Figure 3 Natural gas prices and storage deviation from 5 yr norms
Source: Guiness Atkinson Energy Brief March 2009, citing Bloomberg, EIA (March 2009)

US gas consumption varies greatly from month to month, with peaks during winter heating and summer air conditioning months, and valleys around the equinox months. In 2008 it ranged from 50 Bcf/d to over 80 Bcf/d, and averaged about 64 Bcf/d over the year (EIA).

The current oversupply is estimated at about 4 Bcf/d, and will probably fall to 1 Bcf/d by the end of the year as a result of laying down drilling rigs². Remember, 1 Bcf/d is equal to the recession-induced loss in industrial demand, or about 1.6% of average demand.

When industrial demand returns, our marginal supply capacity will disappear, and we’ll be back in the danger zone for price spikes and possible shortages. . . potentially by the end of this year!

Prices Rising by End of 2009

Chesapeake anticipates the same turning point, issuing a statement on March 2 saying, “U.S. natural gas production will begin to dramatically decline before the end of 2009 and consequently natural gas markets will regain better supply/demand balance by the end of 2009, if not sooner.”

Like oil, the futures curve for natural gas is in a steep contango, suggesting that the market thinks gas is going higher too:

Figure 4 NYMEX Henry Hub futures, 2009-2018
Source: Curving Futures

Another factor in favor of higher prices is that on a Btu basis—the actual energy contained in the fuel—natural gas is selling for less than half the price of oil, a very rare disparity. In normal times, the potential for fuel switching ensures that the two trade in a fairly equivalent way, but the last year has been anything but normal times. It’s a safe bet that in time, that equivalence will be restored, with the floor probably set by oil.

Another often overlooked, yet potentially important factor for natural gas demand is that the ongoing cleantech revolution could cause us to switch loads from fossil fuels to electric power, particularly in transportation, faster than we build renewable energy capacity to power them. That additional demand will fall on natural gas before it falls on coal. This may seem an outlier price factor now, but it could be a potent one in a few years’ time.

When prices do make their next run, they’ll probably stay high, as renewed drilling lags the price by six months to a year. Again, gas is mostly a domestic market; imports are limited in size and LNG growth is very slow. You can’t just order up tankers of imported natural gas like you can with oil.

A Golden Window of Opportunity

The time it takes to raise capital for new drilling, deploy rigs, and start producing again after gas prices rise is a golden window of opportunity for investors. As long as marginal capacity remains in a razor-thin range, prices will stay high and low-cost producers will be rolling in profits again.

While it’s impossible to say when the US economy will recover and bring natural gas prices back into sustainable territory, I am confident that for those with at least a one-year investing horizon, there is no better time than now to begin accumulating those positions.

A stake in one of the low-cost producers shown in Figure 2 would be a fine way to play it, but for now I like getting natural gas exposure not through the producers, whose hedging strategies and rising and falling rig counts will cause their stock prices to moderate and lag significantly behind the price of gas, but by buying into the United States Natural Gas Fund (NYSE: UNG). It invests directly in the near-month futures contracts, so it will respond to rising gas prices fairly quickly.

I realize this is a contrary call. Most pundits, including Cramer two days ago, see little to be excited about in natural gas and expect further selling. The aforementioned analyst at Tristone is actually worried about gas falling to zero, as it did briefly in 2002.

They may be right about further declines over the next few months, but a few analysts like me are expecting gas in the $7-8 range by 2010. With a potential upside of more than 300% within the next two years, I see no excuse for not beginning to accumulate positions now into the cleanest fossil fuel around. I was right about crude four months ago, and I think I’ll be proved right about gas a few months from now.

Until next time,

Chris

1. Units in natural gas vary and can be confusing. For this article I used the more-or-less standard notations Mcf for thousand cubic feet, MMcf for million cubic feet and Bcf for billion cubic feet. (MM represents “thousand thousand”…hey don’t blame me, I didn’t come up with it). 1 Mcf is roughly equal to 1,000 Btu. Gas is often priced in MMBtu, or millions of Btus.

2. Credit to a study by Jon Friese on The Oil Drum, “Natural Gas Supply and Demand Balance,” for his excellent analysis.

 

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