Natural Gas: Extreme Contango Suggests Caution for E&P Companies

The price of Natural Gas is hovering just below $3, which is about the median price over the past two decades. Or is it? While the spot price has garnered lots of headlines recently for its collapse, the future price has declined much much less so. The quoted price for a year from now is above $5. Here is the history since 1990 (oclick to enlarge):

Clearly the spot price is very depressed relative to the future price. In fact, it is at a record percentage differential. In the chart below (click to enlarge), I have divided the one-year forward price by the 1-month forward price. The mean spread has been 6%. You will see I included lines for +/- 2 standard deviations as well. The current relationship is more than 4 standard deviations from the mean:

At this point, I need to alert the reader that I am approaching this from the view of a generalist. Embarrassingly, given that I am both a native Texan for my first 18 years as well as a resident for the past 15, I have never evolved into much of an expert on oil or gas despite my increased efforts over the past several years. However, I do know enough to get myself into trouble!

Kidding aside, though, I think that the "consensus" thinking is that the spot price is depressed and the future price is more reflective of reality, and I have been questioning that notion. A client of mine came back from EnerCom's Conference last month and shared his views. It was then that I realized that the leading E&P companies are all telling a pretty similar story, and it doesn't bode well for the price of gas (and the value of their reserves).

Perhaps I am paying too much attention to the big Shale plays, but it appears that despite the plunge in gas prices, companies are cranking out the gas. Natural gas is more plentiful than we have imagined, and technology makes it more accessible apparently. If that's not enough, I read this week that Cheniere's (LNG) facility is importing gas despite the very low spot prices. Demand is muted, and it could return, but the real story to me is supply. Most commentary points to the large decline in drilling, citing the Baker Huges Rig Count data. Below (click to enlarge), you can see the plunge in North American Gas Rigs in operation:

This data can lead one to conclude that production must be plunging, but I wonder if a lot of the rigs are not the marginal ones. Further, with horizontal drilling, I believe that the output per rig increases. The plunge in spot prices is attributed to a short-term decline in demand and storage at capacity. All we need is a hurricane or a cold winter or hot summer and everything will be fine! In any event, I checked some data published by the Department of Energy and found that production in total has been rather flat. For the first six months of the year, this is what it looks like:

• 2009: 10.515 TCF
• 2008: 10.213 TCF
• 2007: 9.328 TCF

I also believe that we have a situation where reserves are growing rapidly. I reviewed several conference calls from Q2 for the leading gas companies and find an alarming uniformity in what they had to say. While spot prices are quite low and would seem to suggest lower production, they are cranking it out. First, they need to crank it out. All of these companies have significant financial leverage. Second, due to hedging, they are actually very profitable. This begs the question: Who is paying $5 for gas a year out, and how long will they continue to do so?

Here are some quotes, all of which are from transcripts provided by Seeking Alpha. I have included the link to the transcript in each case (click on company name):

Chesapeake Energy (CHK):

...we expect to deliver 4% to 5% production growth in 2009, and 7% to 8% production growth in 2010, plus, increase Chesapeake's proved reserve, during '09 and '10, from 12 Tcfe to 16 Tcfe..." (CEO McClendon) and "...Finally, one note on cost trends. As you can see from our release, just about all of our production and other cash cost are down or at worst to flat from quarter-to-quarter. We continue to see some downward trend in drilling and completion costs as well... (CFO Rowland)

Petrohawk Energy (HK):

...our priorities are significant production growth and reserve growth..." (CEO Wilson) and "... Our production came in significantly over the high-end of guidance to 483 million a day... (CFO Mize)

Southwestern Energy (SWN):

...we will expect to have production growth of approximately 45% over the 2008 levels... During the second quarter of 2009 our horizontal wells had an average completed well cost of $2.9 million per well, average horizontal lateral length of 4,123 feet, and average time to drill to total dept of 11 days from reentry to reentry. This compares to an average completed well cost of $3.1 million per well, average horizontal lateral length of 3,874 feet, and average time to drill to total depth of 12 days from reentry to reentry in the first quarter of 2009. (COO Mueller)

Ultra Petroleum (UPL):

...Second quarter of 2009 was a difficult period for the industry, but Ultra delivered strong results. We established a new quarterly record for production of 44.5 Bcfe, an increase of 30% from second quarter 2008. At the same time we decreased our all-in-cost by 29% to $2.43 per Mcfe, and our cash costs also decreased to $1.42 per Mcfe... We ask Netherland Sewell to provide us with a mid-year proved reserve update using the more logical 2009 rules and unrestricted by us. The result is an answer almost twice what we reported at year end 2008... It is clear to us that we can grow annual production by 10% to 15% over our three-year planning period 2010 to 2012... (CEO Watford)

XTO Energy (XTO):

...natural gas production averaged 2.352 Bcf per day, 31% increase... Of this growth, 19% comes from acquisitions and 13% comes from development...If we look at our unit cost analysis and guidance importantly, and Keith will talk about this a little later, production expense was $0.94. That compares, per Mcfe, to $1.00 to $1.05 guidance, so a substantial improvement there, and we've lowered our guidance to $0.95 to $1.00 going for the remainder of the year... (CFO Baldwin)

So, we have increasing reserves, increasing production, and decreasing costs from these leading developers of the Shale reserves. None of this bodes well for future gas prices, though EOG Resources (EOG) CEO Mark Papa believes that the decline in Texas vertical wells will more than offset this dynamic, calling Texas "the 800 pound gorilla in the room ."

Absent a major change in our national energy policy that results in a massive effort to build gas-fired electrical power plants, I believe that supply will continue to dwarf demand. Investors in the leading gas-focused E&P companies may want to keep an eye on that forward price that is enabling the companies to generate strong profits through their hedging activities.

Disclosure: None

Comments

[eagle01240:]

Maybe, but for months the same was said about oil and it rallied to nearly 75 per barrel. Sometimes a contango is just a contango.

Sep 06 08:21 AM

[Alan Brochs...:]

You raise a good point. I almost replied that it never reached the extreme levels of the current natural gas market, but that would have been wrong. In January, it briefly reached 70%. While less than the 100% spread for gas, that was almost 7 standard deviations from the mean. Even now, it remains at about 2 sdev above the mean.

It's important to remember that gas is primarily a domestic market (actually several domestic markets), while oil is a global one. I checked the YTD global production data for oil (updated through May), and it is down from 2008 (2.4%) and from 2007 (0.8%), unlike what I shared above (gas production is much higher than 2007 and similar to 2008). I am not sure about the demand for oil, but I would bet that it is somewhat less sensitive to U.S. economic growth than gas. I expect U.S. economic growth to remain muted, and, even if emerging countries boom, we don't have a mechanism to get our gas to them. So, the oil rally following contango isn't necessarily a good example for natural gas.

Sep 06 09:00 AM

[wow-me:]

I think oil is different ,oil is more international and sensitive to political events, or it is perceived to be more valuable,it is like gold versus silver,lobster versus monk fish.
There is plenty of gas coming from politically stable countries such as USA and Canada and the infrastructure is in place to deliver that gas ,you dont hear terrorists sabotaging Enbridge or Transcanada pipelines,do you?

Sep 06 09:13 AM

[RECESSIONPROOF:]

e is the problem, p have no choice but to sell their productions far away into the future, it will keep prices very low very long

Sep 06 03:56 PM

[Camden:]

Excellent article. Thanks.

Sep 07 01:29 AM

[mc2406:]

Great article.

Why don't we ever hear from the API or other natural gas lobbyists pushing our professional pols in Washington towards natural gas as the new "green fuel"?

Maybe they could push for government subsidies (such as for farmers) to NOT produce to preserve the excess capacity for the future while the infrastructure is being developed to replace coal fired electric plants and CNG propelled autos?

Sep 07 11:06 AM

[UK Gas Guru:]

Henry Hub gas now sets the world price for gas, which is why we look at it from a UK angle. Apart from the revolution in production, which is only starting to be factored in outside of North America, the big change has been the disconnect between oil and natural gas which used to march in lockstep, and that's all down to the surge in shale and the drop in LNG in Europe and Asian markets, accelerated by the surge in LNG production from Qatar this winter and Australia in the medium and long term.
I agree: the prognosis for gas is not good, apart from the benefits to consumers. The other structural change is the disconnect between GDP growth and energy consumption, which historically moved in lockstep. Energy Bulls who think the "recovering" economy will put energy use back where it was are mistaken. There are now fundamentals pointing to short, medium and long term drops in energy demand in Western economies and a drastic cut in the rate of demand growth in places like China. By themselves, efficiency, renewables, high prices, smart metering, LED lighting, electric vehicles, and carbon targets don't add up to a lot, but in aggregate it means declining demand meeting rising supply.
The revolution in shale production does mean that looking at the past won't provide any pointers to the future: the game has changed permanently. So demand/GDP doesn't cut it any more as a predictor. Similarly, because new rigs drill multiple wells, rig count is out the window as well. Add to that that technologies like 3D seismic make wells much less of a gamble. Two thirds of wells (or thereabouts) are profitable today against one third historically. Volatility depends on market inefficiencies but there's nowhere to hide any more for arbitrageurs. Everything has changed, and changed for good. And for the better for most of us.

Sep 07 11:17 AM

[Alan Brochs...:]

Great points!


On Sep 07 11:17 AM UK Gas Guru wrote:

> Henry Hub gas now sets the world price for gas, which is why we look
> at it from a UK angle. Apart from the revolution in production, which
> is only starting to be factored in outside of North America, the
> big change has been the disconnect between oil and natural gas which
> used to march in lockstep, and that's all down to the surge in shale
> and the drop in LNG in Europe and Asian markets, accelerated by the
> surge in LNG production from Qatar this winter and Australia in the
> medium and long term.
> I agree: the prognosis for gas is not good, apart from the benefits
> to consumers. The other structural change is the disconnect between
> GDP growth and energy consumption, which historically moved in lockstep.
> Energy Bulls who think the "recovering" economy will put energy use
> back where it was are mistaken. There are now fundamentals pointing
> to short, medium and long term drops in energy demand in Western
> economies and a drastic cut in the rate of demand growth in places
> like China. By themselves, efficiency, renewables, high prices, smart
> metering, LED lighting, electric vehicles, and carbon targets don't
> add up to a lot, but in aggregate it means declining demand meeting
> rising supply.
> The revolution in shale production does mean that looking at the
> past won't provide any pointers to the future: the game has changed
> permanently. So demand/GDP doesn't cut it any more as a predictor.
> Similarly, because new rigs drill multiple wells, rig count is out
> the window as well. Add to that that technologies like 3D seismic
> make wells much less of a gamble. Two thirds of wells (or thereabouts)
> are profitable today against one third historically. Volatility depends
> on market inefficiencies but there's nowhere to hide any more for
> arbitrageurs. Everything has changed, and changed for good. And for
> the better for most of us.

Sep 07 03:19 PM

[Ricard:]

Great article and comments, especially from UK Gas Guru.

I'd like to add in a political angle as well. T Boone Pickens has IMHO become a spokesperson of sorts for natural gas and the shale plays, and it's interesting to note that despite the cleanliness of the fuel, he is a staunch Republican - I still remember the controversy behind his support for those swift boat commercials attacking Kerry. I think there are some very good merits to his point about using NG to fuel cars and trucks, which could dramatically increase demand for the fuel in the US.

I wouldn't be surprised if vested interests like Pickens can't wait for a Republican administration to come along so that they can give the credit to 'their' party, for solving the energy dilemma, for providing cleaner fuel, and for cutting our addiction to oil. I'd find it very strange indeed if Pickens and other energy moguls came out and gave a filibuster proof Democratic administration a morsel like this to savor.

In that sense, I wouldn't be surprised if NG rallied along with prospects for Republicans to at least break filibuster next year, and for it to rally further still if in 2012 a Republican had a good chance of de-throning Obama.

Sep 07 05:16 PM

[bobbybutte:]

No one KNOWs what is going to happen to nat gas or oil with certaintity like the person above insuitaed. Markets are just not that predictible and if they were EVERYONE would be on the same side of the trade

Sep 07 05:50 PM

[Boffilicious:]

The difference between spot and forward is accounted for by the storage monopoly. More gas is being produced than consumed leading to a low spot price compared to forward. Storage is filling up and Henry Hub has very very limited capacity to take NG through its pipeline to allow for delivery. Meantime UNG - the NYSE EFT - whether through direct postions in NYMEX NG or indirect positions through financially linked contracts on ICE exchange or OTC swaps, effectively owns 110,000 contracts of the 160,000 open interest in the Oct NG contract (the one month forward contract.) Its roll ensures the contango is kept high. The contango simply being storage fees paid to Centaurus, Chevron and others with access to NG storage caves. Even if you are bullish that Nat Gas will be higher by next year you cannot buy it at a low price because storers will only sell it you at a high price after they have take an annual 100% storage fee between now and next October or a 600% yield on an annualised basis between Oct and Nov of this year! This is quite simply price gouging.

Sep 07 09:30 PM

[Ricard:]

LOL, well everyone is entitled to a difference of opinion. Or, in your case, the lack of one.

On Sep 07 05:50 PM bobbybutte wrote:

> No one KNOWs what is going to happen to nat gas or oil with certaintity
> like the person above insuitaed. Markets are just not that predictible
> and if they were EVERYONE would be on the same side of the trade

Sep 08 02:20 AM

[Mad Hedge F...:]

yuiop. Just when I get comfortable with my view on Natural Gas, I get a scratchy, reverberating cell phone call from one of the major formations telling me that I’m being way too bullish. Gas won’t bottom at $2. The free fall will continue until it hits $1. National storage will be completely full imminently top out, and when it does, the producers will have to shut down completely. Since these guys are leveraged up the wazoo, this will trigger a string of bankruptcies, and the majors will fall like dominoes. A hedge fund bust won’t define this bottom, as these guys are all playing from the short side. UNG can’t step in as a buyer of last resort, as the SEC won’t let it issue more stock, and the current shares are trading at a ridiculous 20% premium. One thing we do agree on is that the bottom will look ugly, whatever the spark is. You often get Armageddon type views near market bottoms, but this guy has been dead on right until now. Well, it takes two to make a market. Conclusion: keep NG nailed to your screen, as the widow maker is where the volatility lives.

Sep 08 11:09 AM

[GotLife:]

Current Congress is not enamored with NG because of carbon emissions. Their base is awaiting "energy with zero ecological impact" and have also decried shale drilling for NG based on water table consequences. Anybody notice the ban on windmills over most of the western states until the effect on the Prairie Grouse is evaluated?

So, we keep burning coal and exploding gasoline. Maybe the OPEC nations and mother Russia ARE smarter than US.


On Sep 07 05:16 PM Ricard wrote:

> Great article and comments, especially from UK Gas Guru.
>
> I'd like to add in a political angle as well. T Boone Pickens has
> IMHO become a spokesperson of sorts for natural gas and the shale
> plays, and it's interesting to note that despite the cleanliness
> of the fuel, he is a staunch Republican - I still remember the controversy
> behind his support for those swift boat commercials attacking Kerry.
> I think there are some very good merits to his point about using
> NG to fuel cars and trucks, which could dramatically increase demand
> for the fuel in the US.
>
> I wouldn't be surprised if vested interests like Pickens can't wait
> for a Republican administration to come along so that they can give
> the credit to 'their' party, for solving the energy dilemma, for
> providing cleaner fuel, and for cutting our addiction to oil. I'd
> find it very strange indeed if Pickens and other energy moguls came
> out and gave a filibuster proof Democratic administration a morsel
> like this to savor.
>
> In that sense, I wouldn't be surprised if NG rallied along with prospects
> for Republicans to at least break filibuster next year, and for it
> to rally further still if in 2012 a Republican had a good chance
> of de-throning Obama.

Sep 08 12:01 PM

[Ricard:]

Agreed that NG prospects are at this point political more than economical. It would take one hellova economy to get people burning gas again, and I just don't see that in the cards.


On Sep 08 12:01 PM GotLife wrote:

> Current Congress is not enamored with NG because of carbon emissions.
> Their base is awaiting "energy with zero ecological impact" and have
> also decried shale drilling for NG based on water table consequences.
> Anybody notice the ban on windmills over most of the western states
> until the effect on the Prairie Grouse is evaluated?
>
> So, we keep burning coal and exploding gasoline. Maybe the OPEC nations
> and mother Russia ARE smarter than US.

Sep 08 12:55 PM

[Mobywhite:]

In the long run (5+ years) NG will be fine.

The production of oil is dropping fast and demand will rise in the short run as the economy picks up. There are simply too many people in the BRIC countries entering the middle class and wanting their cars, TV’s, etc.

We continue to find deep water oil reserves but the cost of extracting and the time it will take to get that oil to market will not make up for the falling supply. Oil will go higher, much higher. And this time it will stay there.

When that happens and the world realizes that we are just at the beginning of this economic cycle NG will suddenly be the fuel of choice and the Republicans and Democrats will be jostling to be the first to find ways to use it.

I am putting my money where my mouth is. I'm long SLB, ESV, HSE.TO, BHP, CHK, ECA, CLR.

Sep 08 01:15 PM

[Elliott:]

Two main reasons Congress is ignoring NG

1. Coal lobby

2. Political calculations -- Pennsylvania is an important swing state in elections, and neither side wants to be punished by Penn voters for causing the loss of coal industry jobs.

On Sep 08 12:01 PM GotLife wrote:

> Current Congress is not enamored with NG because of carbon emissions.
> Their base is awaiting "energy with zero ecological impact" and have
> also decried shale drilling for NG based on water table consequences.
> Anybody notice the ban on windmills over most of the western states
> until the effect on the Prairie Grouse is evaluated?
>
> So, we keep burning coal and exploding gasoline. Maybe the OPEC nations
> and mother Russia ARE smarter than US.

Sep 08 03:55 PM

[Dryspell:]

Ricard - your comment re: partisanship makes no sense. I'm sure Pickens would love for the Democrats to get behind his plan for natural gas. He has a vested financial interest in it. I doubt he cares who gets "credit" for it. Besides the Dems can do it with or without the Pickens's of the world. The only thing stopping them are probable deals with Coal State Democrats and utility lobbyists. As a Republican who works in the natural gas industry I wish the Dems would move forward with a central role for natural gas in our energy policy. It makes economic and environmental sense to do so and I could care less who gets the credit.

I also agree with the author of the article. Prospects for natural gas are bleak if the shale plays turn out as currently touted and new markets cannot be found and expanded. The market should take care of this situation in the long run with consumers moving to the cheaper fuel, but this will take years. I do not agree with the federal "stimulus" plans. However if they are to exist, building out the natural gas infrastructure, increasing NG electrical generation, and building a new fleet of CNG autos would seem to be a wiser way to spend the taxpayers money than what is currently being pursued. It would lessen our trade deficit, put people to work, decrease power costs, decrease emmisions, and require a new fleet of autos for Detroit to build. Too bad our government is more concerned with politics and idealogy than for the people and the economy.


On Sep 07 05:16 PM Ricard wrote:

> Great article and comments, especially from UK Gas Guru.
>
> I'd like to add in a political angle as well. T Boone Pickens has
> IMHO become a spokesperson of sorts for natural gas and the shale
> plays, and it's interesting to note that despite the cleanliness
> of the fuel, he is a staunch Republican - I still remember the controversy
> behind his support for those swift boat commercials attacking Kerry.
> I think there are some very good merits to his point about using
> NG to fuel cars and trucks, which could dramatically increase demand
> for the fuel in the US.
>
> I wouldn't be surprised if vested interests like Pickens can't wait
> for a Republican administration to come along so that they can give
> the credit to 'their' party, for solving the energy dilemma, for
> providing cleaner fuel, and for cutting our addiction to oil. I'd
> find it very strange indeed if Pickens and other energy moguls came
> out and gave a filibuster proof Democratic administration a morsel
> like this to savor.
>
> In that sense, I wouldn't be surprised if NG rallied along with prospects
> for Republicans to at least break filibuster next year, and for it
> to rally further still if in 2012 a Republican had a good chance
> of de-throning Obama.

Sep 15 12:45 AM

[Dryspell:]

Elliot - unfortunately your observation is both true and incredibly sad. I find it strange that in addition to Congress many of the locals in economically depressed northeastern states are also dragging their feet. "Environmental consultants" and local politicians are also throwing up roadblocks. It appears to me that they are just attempting to find out how to get their share of the natural gas revenues. I see the big stink caused by several environmental consultants about hydraulic fracturing and groundwater in Pennsylvania as nothing more than those consultants trying to find a way to extract a living from the new Marcellus industry (nice way to say it). Natural gas extraction is much safer and cleaner than coal extraction and could provide the area with much needed jobs. The consultants know the truth about fracturing and the excellent safety and environmental record of the technology under individual state regulation. They just want to siphon off some of the revenue. Once the local taxing authorities, lawyers, unions, and consultants have figured out how to get their finger in the pie, I expect things to move much faster.
I apologize for the tangent. There are many frustrating and seemingly senseless things affecting natural gas production and the enlargement of the market.

On Sep 08 03:55 PM Elliott wrote:

> Two main reasons Congress is ignoring NG
>
> 1. Coal lobby
>
> 2. Political calculations -- Pennsylvania is an important swing
> state in elections, and neither side wants to be punished by Penn
> voters for causing the loss of coal industry jobs.
>
> On Sep 08 12:01 PM GotLife wrote:

Sep 15 01:07 AM

[Laughing:]

whoops! Really bad call!!!

Oct 15 09:28 PM