One hundred years of natural gas? Not at these prices.
U.S. gas production is declining and shale gas output is down almost 2.5 Bcf per day. Production is decreasing while consumption and exports are both increasing. EIA data indicates a supply deficit by the end of 2016.
Henry Hub spot prices have doubled since early March. Will companies show discipline to preserve higher prices?
Not a chance. They will drill more wells if investors continue to provide capital. This, however, will probably be too little too late to stop the decline in gas production that is already underway.
Real Gas Prices Have Never Been Lower
In February 2016, I wrote that an increase in natural gas prices was inevitable and in April, I wrote that prices would double. Now, spot prices have doubled from $1.49 on March 4 to $2.97 per mmBtu on August 29 (Figure 1).
Still, real natural gas prices (in July 2016 dollars) have never been lower. Average prices so far this year are just $2.20 per mmBtu. That’s the lowest annual price in since 2000 and it is lower than any monthly price except April 2012.
Figure 1. Real natural gas prices have never been lower than in 2016. Henry Hub natural gas prices are in CPI-Adjusted July 2016 dollars. Source: EIA, U.S. Bureau of Labor Statistics and Labyrinth Consulting Services.
Prices have increased because total dry gas production has declined 1.6 Bcf per day (Bcfd) from its peak of 75.29 Bcfd in February. Shale gas production has declined 2.4 Bcfd from its peak of 44.17 Bcfd (Figure 2).
Figure 2. Total natural gas and shale gas production have declined since February 2016. Source: EIA August 2016 STEO, EIA Natural Gas Weekly Update and Labyrinth Consulting Services, Inc.
Figure 3. Shale gas production has declined 2.4 billion cubic feet per day since February 2016. Source: EIA Natural Gas Weekly Update and Labyrinth Consulting Services, inc.
All shale gas plays have declined including the Marcellus which is down -0.64 Bcfd (Table 1). Even the relatively new Utica play has declined -0.12 Bcfd. The legacy plays have declined the most: Haynesville, -3.77 Bcfd; Barnett, -1.91 Bcfd; and Fayetteville, -0.92 Bcfd. No new horizontal wells have been drilled in either the Barnett or Fayetteville since early 2016.
Table 1. Shale gas play declines from maximum production. Source: EIA Natural Gas Weekly Update and Labyrinth Consulting Services, Inc.
Shale gas plays were supposed to provide 100 years of supply but there never was 100 years of gas.
It was a story told to promote the erroneous idea that the U.S. had so much gas that it could afford to squander and export this valuable natural resource. It is true that some of the production decline from shale gas plays is because the plays are not commercial at current prices.
But whose fault is that? Conscious over-production reduced the price below the marginal cost so promoting increased consumption and export became the only ways to increase price.
The U.S. government has been a great ally of the shale gas companies. The SEC changed reserve reporting rules in 2010 making it easier for companies to book reserves and borrow against them. EPA air pollution regulations since 2011 have led to the closing of dozens of coal-fired power plantsin favor of increased dependency on natural gas for electric power thus increasing demand. The U.S. Department of Energy has granted almost blanket approval to applications for LNG (liquefied natural gas) and pipeline export in recent years also increasing demand. And in 2011, the U.S. Department of State under Hillary Clinton created the Bureau of Energy Resources, a 63-person group to promote shale gas export and the spread of fracking technology around the world.
Meanwhile, E&P companies destroyed billions of dollars in shareholder value. They did this by knowingly producing gas into a non-commercial market and then, diluting shareholders by issuing more stock to fund more drilling and production.
Comparative Inventories Tell The Story
Natural gas storage is at near-record levels for this time of year. This surplus distracts from the likelihood of a supply deficit by the end of 2016 suggested by EIA STEO data (Figure 4).
Figure 4. Natural gas supply should go into deficit by January 2017. Source: EIA September 2016 STEO and Labyrinth Consulting Services, Inc.
Periods of production growth led to lower prices and lower gas-directed rig counts. Flat production led to supply deficits that resulted in higher prices and more drilling. During the last deficit in 2013 and 2014, spot prices averaged $4.06 per mmBtu. The ensuing low prices have resulted in less drilling and flat production.
It is, therefore, reasonable that the increase in gas prices since March 2016 will result in more supply but how high might gas prices go before that happens?
Comparative inventories are the best indicators of price trends. Comparative inventory is the difference between current storage volumes and the 5-year average of storage levels for the same week. Figure 5 shows that there is an excellent negative correlation between comparative inventory and spot gas prices.
Figure 5. Comparative inventories are the best indicators of price trends. Source: EIA and Labyrinth Consulting Services, Inc.
That is because the U.S. gas market is a disequilibrium system in which production and consumption are never in balance. During the months of winter heating, consumption greatly exceeds production. Withdrawals from storage provide the portion of supply that remains unmet by production. Once winter is over, production exceeds consumption. Additions to storage restore that portion of supply needed for the next winter heating season.
Gas traders compare the current year’s evolving inventory level with that of previous years to determine if storage will be adequate to meet winter demand. If the rate of inventory buildup is judged to be ahead of expected winter demand, the price of futures contracts decreases. If that rate is deemed questionable to meet winter demand, the price of those contracts increases. Producer response to price signals is typically delayed until a price trend emerges to justify increased or decreased drilling. The potential for over-shoot and under-shoot is great.
Comparative inventory is, therefore, the best measure of the disequilibrium in the seasonal supply chain. It effectively removes the seasonal effects of energy use and plant maintenance that sometimes confuse the interpretation of absolute inventory levels.
Figure 6 shows that the fall in comparative inventories since May 2016 has been significant compared to both the 5-year average and to 2015 inventory levels.
Figure 6. Comparative Inventories (CI) have fallen sharply since May 2016. Source: EIA and Labyrinth Consulting Services, Inc.
Despite falling comparative inventory, prices commonly decrease in the late summer based on probable inventory levels needed to meet winter consumption. Although that may be happening now, I believe that higher prices will prevail by the end of 2016.
A simplified cross-plot of comparative inventory and spot prices suggests a range of likely year-end prices between $3.00 to $3.75 with a most-likely case of of approximately $3.35 per mmBtu (Figure 7).
Figure 7. Simplified 2014-present comparative inventory vs. spot price cross-plot suggests a $3.00 – $3.75 price range for year-end 2016. Source: EIA and Labyrinth Consulting Services, Inc.
Shale Gas Company Performance Is Weak
What will happen if gas prices increase to approximately $3.35 per mmBtu in the next several months? Operators with access to capital will probably add rigs and increase production. That is the correct response to market price signals in a market that believes company claims that they are making money at current gas prices.
This article is for information and discussion purposes only and does not form a recommendation
to invest or otherwise. The value of an investment may fall. The investments referred to in this
article may not be suitable for all investors, and if in doubt, an investor should seek advice from
a qualified investment adviser. More