Natural Gas: Grim Outlook Through Late 2010

Seems like a decade ago that natural gas hit its highs in 2008. Natural gas closed at an unbelievably low price of just over $3. With the winter heating season not starting up again for another few months, natural gas seems destined to fall below $3, barring some miraculous event.

How bad is the current situation for natural gas? Here are some grim stats:

The summer time is generally a time when natural gas inventories climb, but this is worse than normal.

This makes sense, if you look at why. Natural gas wells continue to produce their normal rates, regardless of the season. Most natural gas is used for one of 3 reasons:

• Heating of homes in some northern climates (not applicable in the summer)
• Production of electricity (would be applicable during a hot summer, when air conditioners drive up demand.....however, most areas are having a cooler than expected summer)
• Industrial uses (this has been greatly affected by the economic downturn)

Production should have really tailed off, but hasn't.

Based on the incredible number of rigs that have been decommissioned in North America, combined with the lack of liquified natural gas arriving, the production should have plummeted.

However, this is not the case. The latest weekly inventory levels show that natural gas production is up by over 25% over last year, and about the same percentage over the average of the last 5 years.

This has built inventory levels up to over 20% higher than even the highest part of the range for over the past 5 years. It will take a long time to burn through this inventory.

The last two years have not produced any storms that have disrupted natural gas production in the Gulf of Mexico, as Katrina and Rita did.

Although the hurricane season is relatively young (it can go up until November 1st), the "hurricane premium" has been virtually removed from the spot price.

I do see natural gas making a strong comeback by late 2010 for the following reasons:

1. Shale = fast decline rates. Shale gas can lose as much as 50% or more of its production rate within one year. This simply means that you must punch more holes in the ground than traditional formations, just to keep the same rates of production. With the decline in prices, it simply isn't economical enough to justify drilling new holes right now, even with the incredible reduction in daily rates for most service companies. You can't hold off drilling forever before the production falls off dramatically. I suspect that production will begin to fall off in early to mid 2010. This won't likely be noticed throughout the summer, as this is a seasonably low demand period. The first noticeable time will be around November 2010, when demand will likely exceed supply, drawing down very heavily on inventories.
2. 6:1 ratio... No one believes that oil will stay as low as $65 once the economic engines of China/India get going. So, what happened to the ratio of 6:1, which refers to the ratio that 6 units of natural gas produce the same amount of energy as 1 barrel of oil? The current ratio (over 20:1) is not sustainable, as factories/energy producers and other heavy users of fossil fuels will have no choice but to switch to natural gas as their main energy source.
3. Cash for clunkers. Any significant uptick in aluminum and steel production (whether it is brought on by the uptick in auto production from cash for clunkers, or simply from a drop in Inventories at factories) will dramatically fire up the demand for natural gas
4. US dollar weakness / inflationary worries. This will (indirectly) help virtually all commodities, especially those prices in US dollars. You simply cannot run the printing press for that long without weakening your currency and driving up inflation. It won't be noticeable in 2009, as no one would dare raise prices at this point in the recovery. However, it won't be long before the dollar weakens first (likely in early 2010, when the world stops using the US dollar as a safe haven) and then an increasing amount of inflation, both of which should help natural gas.

Is it too early to invest in natural gas?

Yes and no. Many companies, such as EnCana (ECA) were smart to adopt hedging strategies and have been selling their production at a much higher rate than spot price.

However, very few (if any) companies have hedges in place past January 2010, and the likelihood of getting another great deal is small. So, even those companies who have held in fairly well to date might finally have a leg down.

While prices are down, you may wish to look at companies who use natural gas as a major source of energy, as they are likely seeing higher than expected margins due to the lower input costs. This would include utilities with a high percentage of their electricity generated by natural gas, some chemical stocks (although, this advantage may be negated by the lower demand from the economy) and some fertilizer stocks.

When the prices start to rebound, the best upside will be in the Junior plays and in the oil services. I prefer to play through the oil services, as they tend to be diversified and aren't as affected by local issues. Companies such as Baker Hughes (BHI) are highly tied to natural gas production.

Disclosure: Long ECA/BHI, no current play on natural gas futures

Comments

[tipalia:]

Nice to read you again Larry and very infomative article as usual . Did you write something in the past on canadian energy trusts ? if you did can you tell me how iI can have access to it ? I am curious to see your point of view since we are getting very close to the year 2010 .
Thanks again for helping the small investor like me.

Mike

Aug 18 08:19 AM

[tipalia:]

being a canadian I rather invest in canadian $ because of the negative press on the US$ . I wanted you to understand the major reason of my question . Have a wonderful day Larry !

Mike

Aug 18 08:33 AM

[Ferdinand E...:]

Interesting and very informative article. Are shale decline rates really 50%? I heard something lower, but if they are 50%, that changes a very great deal where the gas supply in the US is concerned.

Aug 18 09:03 AM

[Larry Belle...:]

Tipalia - Thanks as always for your kind words. I've written before on Natural Gas, but never really focusing heavily on the Income Trust side. I'm also a Canadian, but never really cared too much about the US dollar exposure (as you're getting that exposure anyways with the NG price being in US dollars, and many Canadian Producers looking at declaring their earnings in US dollars (like EnCana).

In terms of the Trusts in particular, I like ones that are relatively well split between Oil/Gas, or ones that are more focused on Oil at this stage. Ones like Crescent Point (no position) and Bonavista (no position) are two of my favourite, as they give both nice exposure to the Bakken Oil Play, as well in the case of Bonavista, some nice exposure to the Montney play in NE BC / NW Alberta, for when the Gas price does rebound.

Specifically for Canada, I would look at some of the drillers, but only when you believe that Nat Gas has really turned for the upside. Look at ones such as Trican, Ensign and CalFrac (no position in any).

Ferdinand -- It does sound really high. This is the approximate number that I was given by a Supervisor of Drilling at one of the major drilling companies. I have read higher....

Here is a clip from an article from Ross Smith Energy:

Total U.S. production had remained relatively flat year-over-year prior to a recent increase in gas drilling activity in 2007 that
continued through most of 2008. According to the analysis, the average annual first-year decline rate for new shale gas wells was
relatively unchanged, between 40% and 50%
.
The base decline rate of U.S. production had remained fairly steady at 26% to 28% since 2003. “The decline, which needed to
be fought, during 2007 (declines from 2006 and prior drilling) was around 27%.”

Aug 18 09:28 AM

[naturallight:]

Everyone talks about shale wells having steep decline rates. That is true, but the offshore GoM wells have decline rates that are nearly as steep, and offshore makes up roughly 12% of the total supply, while shale is still around 6-8%.

The overall decline rate for the U.S. is not really changing.

Aug 18 09:38 AM

[Mmarrkk:]

Ferdinand: NO THEY ARE NOT REALY 50%.

They are in fact more like 80% in the first year!! I don't have a link but Range Resources just issued a decline curve with their last quarterly review and it shows the numbers for many of the shale plays. In the Marcellus, month 1 rate is 5000 MCF/day. Month 13 is 1100 MCF/day. And those are averages across the month. The actual Initial Production rate on Day one is much higher than the Month One average of 5000.

So yes, these wells decline very quickly!


On Aug 18 09:03 AM Ferdinand E. Banks wrote:

> Interesting and very informative article. Are shale decline rates
> really 50%? I heard something lower, but if they are 50%, that changes
> a very great deal where the gas supply in the US is concerned.

Aug 18 09:46 AM

[john s. gordon:]

production of primary aluminum requires lots of electricity. in former years Al smelters were located near plentiful hydropower sources (TVA, Kitimat). to what extent has NG-fired generation replaced hydro as a source of energy for the Al industry?
> jack

Aug 18 09:49 AM

[zorro6204:]

"However, very few (if any) companies have hedges in place past January 2010 . . . "

Say what? Try CPNO, EVEP, LINE, MWE, NGLS and VNR for starters, all of whom are hedged beyond 2010, much less January!

Aug 18 10:23 AM

[Rockin L Ranch:]

Informative article on natural gas. I am always interested to read what is said about EnCana as I am in on several wells sites here in Texas.

Aug 18 10:26 AM

[koolsool:]

One could look at low nat gas prices as a positive for the NG industry. Large supply & cheap price for North American nat gas makes it possible to use NG to replace foreign oil & dirty coal for power generation. Thus demand could be increased by a large margin. This would stimulate building more nat gas infrastructure & more storage. This would create a large amount of American jobs & stimulate American business for companies that make nat gas related products, the list is endless. Just think of the possibilities if our leaders would put together an energy policy that replaces foreign oil & dirty coal with North American natural gas.

Aug 18 11:02 AM

[Mad Hedge F...:]

cvbm. I love it. The fat lady is singing on natural gas. Not only did we plunge to a multi month low of $3.10/MCF, the crude/gas ratio blew out to yet another new high of an amazing 21 times, wiping out yet another generation of quant players. How many standard deviations is this? Their computers must be melting from the models that are exploding. Didn’t anyone tell them these are just tools, and not gospel? The big providers have just not been able to shut down production fast enough. It looks like Chesapeake Energy’s Aubrey McClendon (CHK) is going to have to sell more of his wine collection and artwork (click here for their website). I have been overwhelmingly negative on NG since early June, (click here for report) , suffering an Internet full of abuse in the process. But you want to buy the final washout, because market conditions are bound to improve this winter. Let’s see if you can get a $2 handle, which traders have not visited this century.

Aug 18 12:18 PM

[Mmarrkk:]

Mad: Beg to differ with you...we have visited $2 this century. In fact, it was only a few years back when prices were below $2! And that's at the Henry Hub index. In the Rockies, we were selling gas at $0.50/mcf at the well head.

Aug 18 12:24 PM

[LoveShorting:]

koolsool: you are correct of course and this would work if we had even 2 honest politicians not owned by one lobbyist or another in DC. But Ron Paul may be the only one left and you saw how he did in the recent election. A better America requires educated voters. Draw your own conclusions. Knowing is one thing, changing things is another. I wish that for just once, Washington would do the right thing, but alas, if wishes were horses then beggars could ride and I am old enough to know better (unless more citizens start showing up at political events with assault weapons? Like the guy at a recent Obama event? One can only hope)

Aug 18 03:22 PM

[Barbarous R...:]

Gas production up 25% over last year??? Don't know where your data comes from, but this is off-the-charts wrong. The latest EIA data (May) shows production 3% higher than last year and falling. I'd be very surprised if current production isn't already down from last year.

Once we get to full storage this fall, the game begins anew. And with gas drilling activity cut in half, look for a much stronger gas price in early 2010.

Production will fall off quickly and LNG is a non-factor. The greatest risk is the overhang of shut-in gas -- however, this probably doesn't hit the market until prices are much higher.

Aug 18 05:57 PM

[Buck East:]

"With the decline in prices, it simply isn't economical enough to justify drilling new holes right now, even with the incredible reduction in daily rates for most service companies."

They are drilling new holes because they are compelled to replace their reserves, and because some cash flow is better than none when you have so much debt like most Shale E&Ps.

Baker rig count up for last five consecutive months.

Aug 18 06:17 PM

[Wiskey:]

"This has built inventory levels up to over 20% higher than even the highest part of the range for over the past 5 years. It will take a long time to burn through this inventory."

After I read to this point I stopped reading and advise the author to try other things then writing about Nat Gas. "Long time to burn" he says. How long Larry? The 3.8TCF "inventory" is burnable in two month using 60BCF per day rate. Tell that to readers...

Aug 18 07:05 PM

[Larry Belle...:]

Ok, a lot to digest here....here goes some comments:

Naturallight - That is scary. My point was more that Shale Gas (which is deemed the saviour to the US Foreign energy crisis) declines fast. I don't have as much knowledge of Off-shore, but if you are right, that is crazy.

Mmark - In the article, I talk about someone at a drilling company. He did mention that he had seen them that high, but 50% was more the norm. Either number is scary, considering the lack of production.

Barbarous - My source was the US Natural Gas Inventories report for August 13th (by EIS). It shows that storage from Producing wells climbed up to 1073 Bcf, which compares to the 5 year historical comparison (2004-2008) of 794 Bcf. Maybe the actual production isn't up, but the storage produced from producing wells is up. I probably should have worded it different.

Buck East - depends on what your cost per well is. Some of the deep wells aren't economical as less than $6. Other formations are much less complex to drill. Baker's rig count may be up compared to other months, but the more accurate comparison is to compare it YoY..

Aug 18 07:07 PM

[Larry Belle...:]

Wiskey -- thanks for your note. Your assumption is that production will stop completely, and everyone will just burn through all of the inventory. If that were the case, you have a point. Since production just not just stop, do you really think we will burn through our excess capacity in that little of time?

If I accurate knew the exact answer as to how long it will take to bring supply down to a more normalized levels, I'd be much richer than most people. The reality is that Natural Gas is very much linked to weather, and unless we have a very hot August/September, then a really cold start to fall and winter, this inventory is not going to be burned off anytime soon.

You're entitled to your opinion, but it should be noted that your comment on how fast we can burn through inventory isn't accurate. The world's energy producers aren't going to seize production, just not bring on new production....

Zorro -- the reality is that most producers that I follow would not have hedged more than 30-40% of their production that far out, when prices were good. My point was more a long the lines that most producers who have hedged are likely to see a significant drop in revenue as those hedges come off....your point is well taken, but I would expect that it is more the exception than the rule to see hedges of really high values (say north of $6) and high percentages (say north of 50% production) for too far into 2010

Aug 18 07:23 PM

[Larry Belle...:]

That should read "....would not just stop" on the third line

Aug 18 07:24 PM

[Wiskey:]

I don't know what numbers you refer, Larry, in your "analysis" but here is a word form energy exec for you. I'm copying and pasting in full (I hope this will educate you little more on a subject you posting):

----------------------...
EOG Bullish in 2010, Sees $7.50-8 Gas Prices

North American natural gas prices are expected to "remain quite low" through the end of 2009, but EOG Resources Inc. is even more bullish about 2010 and 2011 than it was earlier this year, CEO Mark Papa said Friday.

EOG's domestic gas supply model "is telling us that December 2009 domestic production will be 4.8 Bcf/d lower than year-end 2008, and this deficit will deepen further throughout 2010," Papa told financial analysts during an earnings conference call. He shared EOG's macro gas views and detailed the company's 2Q2009 performance.

"When added to the Canadian supply drop of at least 0.8 Bcf/d, we expect the gas market to turn sometime early in 2010, almost regardless of what happens to LNG [liquefied natural gas] imports," he said. "Everybody seems to be focusing on the supply growth from new horizontal plays, but the 800-pound gorilla in the room is Texas vertical gas production. This represents the largest single block of production in the U.S, 16.3 Bcf/d in December 2008, and the rig count here has fallen from 450 rigs in January 2008 to 145 rigs today."

EOG's model "shows production from this large segment of domestic production will fall from 16.3 Bcf/d at year-end 2008 to 13.2 Bcf/d by year-end 2009, and then to 11.6 Bcf /d by year-end 2010, down 4.7 Bcf/d over two years," Papa noted. "In my opinion, this is the most important well population that people should be focusing on if they want to understand what is going to happen to gas supply over the next 24 months."

EOG has hedged almost half of its North American gas from July through December 2009 at $9.03/Mcf, but it has only a "small amount of first-half 2010 gas hedged at $10.27" because of its optimism on gas prices, said Papa.

"We believe that the gas price for 2010 is going to average full-year somewhere between $7.50 and $8," he said. "And I know that sounds dramatically bullish relative to today's Henry Hub price. So we would have to see a price that amount or higher before we would consider hedging for 2010...Our overall 2009 production growth target of 5.5% is still intact, but I will caution investors that this assumes we don't curtail any North American gas in the second half because of market storage issues" (see related story).

EOG, whose production as late as a year ago was weighted to gas, now is about half-weighted to oil projects, including a development in the Bakken play in North Dakota and oil projects in the Barnett Shale of Texas.

Aug 18 09:23 PM

[Larry Belle...:]

Wiskey,

To add to my points above, I'm not saying that Natural Gas is dead forever. Everyone believes that prices will rebound. It is a matter of opinion when one thinks that they will, not a matter of fact. NOONE knows for sure. Not even Execs at EOG.

EOG may believe that Natural Gas is going to rebound like they do, that is their belief. Most analysts, as you know, since you follow it as close as you do, do not believe what EOG is saying. As well, since you also know the business as well as you do, you'll know that Service companies are not as booked up for the Winter drilling season as they would be, if the overall market was of the same belief as EOG. Many of my customers are Oil/Gas Services companies, and they have been told by the Producers to expect a lighter than normal drilling season, which for Canada, means a drop from over 25000 new wells that they saw in 2006/07, down to a lower 12-15K in the Winter 2009/10 drilling season. It is also light for Summer 2010 bookings.....Where is this bullishness?

I'm trying to see where you are coming from, but the market simply doesn't seem to think this is true. Natural Gas futures for February 2010 are only trading in the $5.50 range. If the belief was as obvious as you say, where are the hedge funds? They live for this stuff.....

The likelihood is that EOG didn't think that Natural Gas rates would be too low in the first half of 2010 when they put the hedges in place (a long time ago, I presume).....they are not alone, most companies didn't. When they bought the hedges, Natural Gas was on its way to $13 and beyond. EnCana, which is the example that I used, is probably the premier run Producer in North America, and even they didn't hedge to the extent that they needed...

Now, I'd love to be wrong, I'd love it if you were right. I make a lot of my living selling equipment to Natural Gas drillers. Unfortunately, it is that insight into the market that I get from talking to them daily that further exemplifies my belief that we will not see a big rebound as fast as you predict.

Just look at the EIA inventory. Based on the current pace, we may top out at close to 4 TCF by the time we start drawing from Inventory in November 2009. In order for inventory to hit its normal range by April 2010 (just normal, not low), we would have to draw about 2.6. Considering that the average draw in the past 5 years has been about 1.8 to 2, it would have be a pretty nasty cold winter, combined with a spike in demand / disruption in supply to have a chance. To see that happen by January 2010, we would have to be down to about 2.2 TCF, a draw of 1.8 TCF in two months! The average draw down from 04 to 08 is half of that....Impossible? No, but would you want to bank on that?

Again, I'd love to be wrong. I'd love to see us with $9 Nat Gas in December, at which time I'll gladly write a glowing retraction. It would just take an awful lot of things beyond the Industry's control for this to happen. Producers are doing what they can, as EnCana, CP Canada and Suncor/Petro-Canada, along with a few US ones have announced production cut backs.

I appreciate your attempt to educate me. Please do remember that I live in Calgary (where we live and breathe Nat Gas), and have a lot of access to key people in the Industry.....all of which who would love to see EOG's scenario develop. They just don't believe it (re: see production cuts above)

Cheers....keep up the comments, I love having debates, it is what makes this fun. I don't get any money for this, but rather, it is something I do in my spare time.

Aug 18 10:05 PM

[H. T. Love:]

Feb 970



Mar 810



Apr 742




May 703


End of month counts, NG only for last 8 months:
Feb 970
Mar 810
Apr 742
May 703
Jun 687
Jul 677

HardToLove

On Aug 18 06:17 PM Buck East wrote:

><snip>
> Baker rig count up for last five consecutive months.

Aug 20 12:40 PM

[H. T. Love:]

Well, I've never copied from a spreadheet before. So the results reflect that. Let's see if I can clean it up a bit.

HardToLove

On Aug 20 12:40 PM H. T. Love wrote:
<snip>

> End of month counts, NG only for last 8 months:
Dec 1347
Jan 1150
> Feb 970
> Mar 810
> Apr 742
> May 703
> Jun 687
> Jul 677
>
> HardToLove

Aug 20 12:44 PM

[Mmarrkk:]

Larry: I've looked at hundreds of shale wells production curves. Believe me, there are only a handfull that are "only" declining at 50% in the first year. Most are in the 70-90% range; the new play, the Haynesville, is running 80-85% UNLESS people are choking back the wells due to low prices and/or pipeline constraints. In those cases you will see very low to zero decline for a few months but that's not a good thing either.

Scary is probably too gentle!

Related to EOG's comments: maybe they believe gas prices are going up but they are funnelling more money to their "oily" plays. Actions trump words! Plus, why wouldn't the CEO pump gas prices? He owns a gazillion stock options that stand to benefit if people BELIEVE prices are going up!

Aug 21 09:15 AM

[mn33:]

"Is it too early to invest in natural gas?

Yes and no"

great answer- sounds like something a spineless chimp might say.

Sep 03 08:00 PM

[Larry Belle...:]

Wow, mn33....I'm glad you actually read my answer before making such a comment! =)

The reality is that it depends on what your timelines are. If you are a short term trader, it proved wise not to get involved in any NG-related activities. However, NG is the fuel of the next 10 years, and this would prove to be a good long-term entry point if you were patient.

But, I guess you didn't bother to read that far!

Oct 02 09:52 PM