Natural Gas: a Supply Shock in the Making

Things are rough all over, and today we're going to look at natural gas.

The U. S. Energy Information Administration reports that while there was a drop in natural gas inventories of 102 billion cubic feet for the week ending March 4 due to cold weather and the increase in heating demand that goes along with it, underground inventories are still high. In fact, as the EIA points out, that 102 billion cubic feet drawdown is 19 billion cubic feet lower than the average inventory drawdown at this time of year.

The U.S. is sitting on a whole lot of stored natural gas right now - 1,793 billion cubic feet to be exact - 13.8% more than the five-year average. Keep in mind, this is gas that has been taken out of the ground in one area, processed, transported and then pumped back underground into salt caves and other underground natural gas storage areas. Crazy, isn't it?

And here we sit with spring just around the corner - a time when we usually see a seasonal dip in natural gas prices as the weather heats up and demand drops. At this point, natural gas has nowhere else to go but down ... again.

But even the weather hasn't helped natural gas prices much this year. In fact, from the look of the chart below, you'd think this was an exceptionally warm winter. From the view out my window (and at my thermometer, which read 13 degrees last week), you'd be wrong.

For the past 12 months, the picture looks like this:

Henry Hub natural gas has fallen 70% from a high of $13.27 on July 2 to a recent low of $3.95 on Friday. At this price, many natural gas operations just can't make ends meet, needing prices instead around the $5-$6 mark, or even $8. The bad news may not be over - the Financial Times reported that analysts with Strategic Energy and Economic Research see gas falling under $2 by summer. Would anybody produce gas at that price?

Production Cuts

Suppliers are already trying to scale back production, but run into similar problems that OPEC and other oil producers encounter when cutting production - the cuts take a while to flow through the system and affect prices.

One way to look at how much suppliers are cutting is to look at the number of rigs that are in service. The latest numbers from the EIA weekly Natural Gas report show that the number of natural gas rigs for the week of Feb. 27 fell down to 970, from 1,018 the week before. Last year at this time, there were 1,418 rigs working. The highest number of rigs working on record was 1,606 on Sept. 12, 2008. The EIA has this handy chart that shows the relationship between the number of rigs and natural gas' spot price:

As you can see, the number of gas rigs had been growing slowly and fairly steadily over the past five years until September, and then they started dropping. This was about a couple of months after July's high prices and the subsequent crash of the commodity market. The number of rigs started dropping pretty quickly once the price started falling, but not as quickly as the price did.

Now we are at a point where suppliers, such as Chesapeake Energy, are continuing to cut production, because the price is so low that many cannot cover their costs.

"During March 2009, most Mid-Continent natural gas prices at major interstate pipeline delivery points will average around $2.70 per thousand cubic feet, a price at which most natural gas production is unprofitable," said Chesapeake's Chief Executive Aubrey McClendon.

What Does That Mean For The Future?

Well, for one thing - the independents may be harder hit than the big boys like BP. As Ben Casselman with the Wall Street Journal noted on the publication's Environmental Capital blog:

When prices were rising, it was the fast-moving, free-spending independents that had the edge. Now that cash is tight, the more conservative, cash-hoarding majors are better positioned to ride out the storm."

On a positive note, due to the natural gas markets' geographical differences, things are not bad all over for the independents - at least not yet. Areas like western Pennsylvania are still seeing new well development. As the Pittsburgh Tribune-Review reported, some companies are still able to continue to drill:

Many companies have contract commitments which have to be met, and internal cash flows still allow wells to be drilled," said Steve Rhoads, president of the Pennsylvania Oil & Gas Association. "As long as there is access to capital, drilling will continue."

If natural gas prices drop further, into the $3 per thousand cubic feet range, there could be a significant drop in drilling statewide, he said.

But if prices continue to remain low, even BP with its deep pockets won't be able to continue pumping. Add to that the reduction of investment, development and the drilling of new wells, and it looks like we've got a supply shock in the making. It will only be a matter of time.

Comments

[A Barrel Full:]

It is clear that long term, more investment must be made in infrastructure, to get natural gas to areas that are not able to use it.

In the short term it is going to get very ugly. World LNG export capacity is to rise by a third this year, just as demand falls.

Mar 10 04:29 AM

[Paul Harper:]

the winners are those that can extract & distribute LNG easily, such as Qatar & perhaps Indonesia.
As A Barrell Full writes, lack of infrastucture investment will hit the US providers hard

Mar 10 05:50 AM

[yellowhoard:]

This is just a microcosm of nearly every resource in the world today. Crashing demand and supply, followed by soaring prices not far down the road. When prices begin to climb they will go hyperbolic pretty quickly.

Mar 10 06:37 AM

[User 373120:]

The concept of producing the gas and then reinjecting into storage is not "crazy" as your article suggests. Doing this provides two very important benefits.

The first is that much of the storage is located near the market areas. This storage is filled on off-peak days when cross-country pipelines are not running at maximum capacity. On peak days, when the cross-country lines are at maximum capacity, the stored gas can be delivered to the market with local infrastructure.

Also, other storage along the gulf coast can be drawn upon during hurricane season when offshore production is shut in, then ensuring a supply of natural gas for the cross-country transmission lines when large production volumes offshore are unavailable.

Mar 10 07:44 AM

[Perry1961:]

I'm expecting a summer rally in NG. Demand will drop for seasonal reasons,but production will drop a lot faster. NG wells have initial depletion rates of 50%. As much as 70% in shale areas. Cut drilling,and production declines are almost immediate.

Mar 10 08:40 AM

[pockyclips ...:]

Why the heck are we converting vehicles to NG? This is insane! The middle class is being thrown out of work,
and three years from now there will be a labor shortage in energy. Efficient capitalism, I think not.

Mar 10 08:46 AM

[Fred W:]

Easy to see, yet very little will be done to change the probability of the outcome. NG vehicles are simply fools gold.
fyi- capitalism cannot be efficient as long as the likes of Freddie and Fannie exist for the "common good"--ever been to the extravagant offices of F&F? Ridiculous opulence and arrogance to match.


On Mar 10 08:46 AM pockyclips 2020 wrote:

> Why the heck are we converting vehicles to NG? This is insane! The
> middle class is being thrown out of work,
> and three years from now there will be a labor shortage in energy.
> Efficient capitalism, I think not.

Mar 10 10:03 AM

[Ferdinand E...:]

Very informative and interesting. And yes, buyers should enjoy these low gas prices, because eventually they will have to deal with some very bad news.

Mar 10 10:06 AM

[Jim/ Longte...:]

The time from well rig completion to production usually runs about 6 months. We are still seeing production come on from the peak of rig utitization in Sept 2009 at 1606. Currently there are 916 rigs under contract as of 3/6/09. That is a drop of 690 rigs in 25 weeks. Over 27 rigs per week or nearly 2% per WEEK. We have already started to see production drop in the US from 64.51 BCF per day in January to 62.86 in Feb and so far to 62.67 in March. If you believe in supply and demand, production will continue to fall until at least until next September. This production drop will drive prices up at the well head from $3 per MCF to $6 per MCF. IMHO. Jim

Mar 10 10:14 AM

[Mike the Tiger:]

Erosion of product prices is a disaster for independents at this time. Independents do most of the drilling in the US and, because the credit crisis has taken most of the funding off the board, independents will limit drilling to net cash flow. And with low product prices comes little, if any, net cash flow. Also, because everyone was working last summer and demand for rigs and services was high, Capex was higher than expected and production is now coming on line at much lower realizations and net cash flow to pay the bills for last year's work. The independents working in the deepwater have it even worse. In order to get a rig last year, you had to sign term contracts at those inflated prices. They're still having to pay for those DW rigs with limited net cash flow, further compounding ability to do work elsewhere.

Mar 10 11:30 AM

[HiSpeed:]

At these prices, I've locked in a fixed rate with one of my local gas company's suppliers, so as to be set for next winter, should rates tick back up. (Should rates get lower, the contract has no cancellation fee which makes it even better). I think it prudent for folks to do this if they have that option.

Mar 10 11:31 AM

[samwise:]

One thing I don't understand--if you don't have the money to cover your costs why cut production? Shouldn't you be producing to the maximum extent possible? Bankruptcy in the energy patch in this environment would be a dream come true to the financing crowd. They already bagged some clown in Tulsa who gambled his hugely profitable natural gas business away, right? Now in a time of rising energy prices companies like Chesapeake think the right response is to cut back? Sounds like Saudi Arabia. Label 'em terrorists, buy 'em for peanuts and ramp up production until every motor vehicle in America is powered by CNG.

Mar 10 02:04 PM

[Rohan C. Pease:]

I understand the over supply due to ramped up production, however I do see a short term pop in Nat Gas Prices, if crude does break the $65bbl mark. Be long PBR and RIG.

Mar 10 03:38 PM

[fireball:]

thanx for the article. would love to catch ng way down again. last time i did pretty good. ngs did o.k. for me too. i probably won't be converting my vehicle. looks expensive and troublesome and asking for tax breaks, subsidies or favors stinks a little like welfare to me. am i mistaken in thinking the private sector built the present fueling infrastructure for gasoline with profit as the incentive? if ng can do it this way i'm all for it. go for it. it would be a good supplement to help bridge the gap as we work toward u.s. energy independence. right now it only seems practical for short range fleets such as federal express or ups. since gas and oil both come from drilling and we need both why do we seem to have an outcry to not drill? it looks like a double plus as far as u.s. prosperity is concerned. cheap transportation lubricates the progression of civilization.

Mar 10 04:33 PM

[jack kreg:]

LNG fueled cars, buses and trucks;
-cleaner burning that gasoline or diesel,
-abundant in No. America, NA
-currently low priced in NA

LNG car technology is in place, does not require gov investment or subsidy, compared to Li Ion battery, where plenty can go wrong, investment costs continue, etc.

Seems like a low priced LNG car, burning a low priced fuel is a great thing for the American middle class, which is currently under massive financial distress.

Why cant we get;
a major push for LNG cars for the masses.
Where is Henry Ford when you need him, America needs a low priced car, $12,000, that auto workers can afford when making $20/hour.
Thats a business that puts America on the road to recovery.

Mar 10 08:12 PM

[tedfoo:]

I do believe there is some potential for a pop in NG price as a result of declining production during this period of historically weak demand after the boom of last summer. However, I think any move is going to wait for quite some time...maybe a year or more.

Any near time rise in NG will quickly be combated by companies resuming production on NG reserves discovered this past year. Most have already staked their claim and in many cases laid the ground work to resume production of NG when it becomes profitable to do so once again. In essence they're just sitting on their eggs. No point in selling what they have now when margins are low when they can wait a while. At least the well positioned and capitalized companies can afford to wait. But some can't!

Now is when it pays to buy stock in companies who didn't go all in during the boom days and are swimming in debt...CHK comes to mind. I think companies that stayed conservative and have large amounts of cash on hand and low debt now are in a position to buy leases off debt burdened companies cheap and position them nicely for the price run up in a year or two down the road. Over the next year I will be accumulating the BP's and EOG's of the world when LNG is at it cheapest and wait for the inevitable return to $14 NG in a year or two or three. I expect these shares will triple, but pay me a dividend while I wait...because honestly who knows how long it will be before NG recovers.

Mar 10 10:09 PM

[Mmarrkk:]

Sam: It isn't that the companies cannot cover their cost. They cannot afford to invest NEW capital. The cost to operate a natural gas well is usually in the $0.50 to $1.00 per mmBtu range. So, once the well is drilled and hooked up, the operating costs are relatively low. But to drill the new wells, that will cost you somewhere in the $4+ per mmBtu range and that's why many can't drill new wells.

So, if the companies simply stop investing new capital, they will have good profit/loss statements but will not be growing...either their company or our country's reserves.

Why do companies shut in gas? Quite simply its because there is too much gas on the market. We are oversupplied by 4 BCF/day. So they shut in the wells to bring all of the prices up as supply and demand come back in to balance.


On Mar 10 02:04 PM samwise wrote:

> One thing I don't understand--if you don't have the money to cover
> your costs why cut production? Shouldn't you be producing to the
> maximum extent possible? Bankruptcy in the energy patch in this environment
> would be a dream come true to the financing crowd. They already bagged
> some clown in Tulsa who gambled his hugely profitable natural gas
> business away, right? Now in a time of rising energy prices companies
> like Chesapeake think the right response is to cut back? Sounds like
> Saudi Arabia. Label 'em terrorists, buy 'em for peanuts and ramp
> up production until every motor vehicle in America is powered by
> CNG.

Mar 11 10:05 AM

[harm38:]

Well boys, here is the bad news. With natural gas prices down so far and the economy at a standstill drillers are going out of business left and right. In the near/distant future prices will rise and demand will outreach supply. hard to believe but it will happen.

Mar 21 09:07 PM

[tunaman4u2:]

You were right, supply shock today has nat gas under $4 while oil continues to surge on the same oversupply news...
Get them apples.
Exxon did a great job of lobbying Congress to ignore nat gas as a viable energy because the US doesn't have enough.
Exxon wins... what a surprise

Mar 26 01:56 PM