Natural Gas Production Outlook: Decreases Are in the Offing

It’s been a brutal summer for natural gas investors. Much has been written about the enormous discount for natural gas when compared to oil in energy terms. And, remember, natural gas energy comes with smaller carbon and pollution footprints, so if we lived in a truly rational world (a big “if”), gas arguably should be priced at a premium to oil, not at a discount.

Instead, natural gas is dirt cheap and making new multi-year lows as the summer ends. There’s been plenty of hot money piling into long plays on both the commodity and into the UNG ETF but so far it’s been a bad investment. Right now, it almost looks like natural gas is on the way to becoming free. Yet production is hovering near all time highs. Something is wrong with this picture, but it takes looking a little closer at the data to see what’s really happening.

Here’s the U.S. monthly natural gas production data for the last three decades up to June of 2009:


A naïve look at this graph of U.S. natural gas production could be used to argue that we are in a new era for natural gas where increased production is the norm. There is certainly more reason to be optimistic about U.S. domestic gas production than there is for oil. In fact, I sketched out the arguments for this “new gas era” several months ago in an article in the Journal of Energy Security. There has indeed been an increased focus on drilling for natural gas, and recent higher prices have stimulated the development of better techniques, particularly in the increased use of horizontal drilling and fracturing to produce gas from tight formations.

However, as I said in that article, I am deeply skeptical of the “new era” argument, and a closer at the production data bears out this skepticism. Instead, gas production looks likely to fall very soon. In fact, viewed carefully, production is already falling. To see this, the key is to look not at the raw production data, but instead to graph out the year-over-year change in production. This simple change, looking at the year-over-year change in production, does two important things:

1. It is the simplest way to seasonally adjust the data, which is important because there is considerable seasonal pattern in natural gas production (this seasonal pattern had been less pronounced lately, but it is still significant). To the eye much of this pattern looks like noise, and a year-on-year plot lets you “see through the noise” and gives you a much clearer picture of what’s happening in the production data.

2. Graphing the year-over-year data is a simple way to graph the rate of change (the first derivative, in the mathematical sense, rather than the financial sense) and also lets us see the second derivative easily, too, which is just the slope of the year-over-year plot. (Let me here divulge a little secret of quantitative financial analysis: it is this second derivative, the acceleration, that is often most important in predicting future prices.)

Here, then, is the year-over-year natural gas production data up to the month of June 2009:



The data are much tighter and the current trend is now immediately clear. Natural gas production is not continuing unabated while prices sink to new lows. In fact, the seasonally-adjusted rate of change of gas production has been decreasing for about a year and is now right at zero. Even more important, the data give every indication that U.S. natural gas production is likely to begin falling very soon. This is likely because the deceleration (the 2nd derivative) of year-over-year gas production is strong, and notably stronger than recent production decelerations. (By the way, after mentioning the 2nd derivative again, it is appropriate to give a shout out to the math teachers of the world: your calculus teacher was right when she said calculus really did matter in the real world….).

The steep deceleration of gas production is not actually very surprising. Much of the recent spike in production has come from new gas from tight geological formations. There is a lot of this stuff, but it is expensive to produce and—even more importantly in this discussion—the production from wells in tight formations typically falls off much faster than production from conventional wells. Once you’ve produced the gas from the area you’ve laboriously horizontally drilled and artificially-fractured, the lack of natural permeability of the rock turns off the spigot. But recent prices have cratered gas drilling activity, so the upshot is that there are a lot of spigots that are turning off right about now.

So what does this mean for natural gas prices? Production is, of course, only half of the equation; the other half of the equation is consumption. Where consumption goes depends a great deal on the health of the overall economy. But if you are reasonably optimistic about the economy, falling natural gas production is likely to at least put a floor under gas prices. Whatever the economy does, given the story the gas production data are telling, one would certainly expect the ratio of natural gas to oil prices to move back into its more normal range, reflecting more closely their relative energy values. This would imply a large relative increase of gas prices, compared to oil prices.

Things can change, of course, and commodities are especially unpredictable at times; but given the data above, it is becoming very hard to make a case for even cheaper natural gas. In fact I believe that the tide may turn sooner and more aggressively than many market participants expect.

Disclosure: The author currently has long option positions on UNG, as well as long positions in the energy-correlated securities SU and PBW.

Comments

[elliot_mllr:]

Excellent analysis. I only hope that the real world does follow the math.

Sep 06 10:05 AM

[john s. gordon:]

if we can manage to start manufacturing things again in this country (a big if), NG consumption will increase.
> jack

Sep 06 12:10 PM

[RECESSIONPROOF:]

if this is the fact, then ng price is crazy, but as price is always based on all the knowledge possible, then i doubt it

Sep 06 03:55 PM

[bilbobaggins:]

i really don't get how you came up with the year over year difference, care to explain please? Is this the monthly prodcution in year X subtracted from the monthly production in year Y....I don't think it is

Sep 06 07:36 PM

[Ruffdog:]

Perhaps it is the other way around. The availability of cheap NG to power our factories will increase US production of products at home?


On Sep 06 12:10 PM john s. gordon wrote:

> if we can manage to start manufacturing things again in this country
> (a big if), NG consumption will increase.

Sep 06 08:20 PM

[Aricool:]

why can't it go under $2? If most of the producers are 100% hedged for '09 (hence likely why their stock prices are not in the toilet w/ NG price) and they have to produce to keep their valuable leases and we have a 100 year supply, then why stop production at any price when you're getting top (hedged) $ any how??? Someone needs to explain to me why will they given these (and many other simar) factors.

Besides, did you notice that rig counts bottomed in early June and actually started to uptick in July-Aug. Also, day rates never came down enough. Not a good sign if you believe in major production cuts.

Also, if you look at the last recessions NG droped to around $2.5-2.7 in real terms (adjusting for inflation); however, that was when US NG production was believed to have peaked, which is why we later created infrastructure for LNG imports- and those lows were before we became the Saudi-Arabia of NG with massive supplies. So, it would stand to reason that we'll see below $2 easy; esp. since we got so quickly to $2.5 w/o resistance.

Moreover, I'm very concerned about the long term pricing of NG. I'm trying to see it as bullish as you do, but many long-term factors seem like it might keep it very low- not the least of which is LNG imports from Russia and Arabs when NG gets back over $4.

Have a look at the LNG import spike between end '06 and early '07 and it tracks *exactly* with a step down of NG price from 7 to 5. This is insane that LNG could crush prices during a robust US economy. I'm very scared now that with the paltry 2% trend growth expected for the US (and EU?) going forward that they'll dump excess Euro LNG onto the US and repeat that '06/'07 event. This would almost certainly keep NG prices under $4 in the expected weak situation for '10. This is a huge uncertainty in playing '09 weakness esp. if buying into NG driller/services securities to play the "perfect storm" against NG. That is, the LNG would dump just enough supply to easily keep the storage full, thus keeping NG exploration and cap ex down to a minimum, and b/c most NG producers are only partially hedged for 2010 (maybe 30% or less?) then they would get killed in 2010 making there hedged supported stock prices 2009 quite high. This uncertainty really sucks! Can you discount this scenario?

the EU is expected to recover more slowly than the US so why (in the context of those reports/articles I sent you) won't the LNG plays dump what ever they can on the US. As I analyze the charts, the LNG chart tells me a very bad story. That is, the June '09 LNG was sold at only ~ $4.3 while volumes where a little above that just before the '06 event (see above) when NG price in '06 was ~7, and then dumped 2X the volume for 6 months and were more than happy to collect only $5 in that time. Again, this was when the EU and US were heading into a peak earning cycle. This tells me that the LNG players will keep US NG prices in the toilet (<$4) until the US (and EU?) are in a full recovery. Very, very bad for NG sector stocks for 2010. Please debunk this gloom and doom scenario! It seems all too possible if the magal V-shape recovery does not materialize in early 2010. Hence, why with a weak EU they'll dump there LNG at a (double? june '09) high rate and keep the US storage near max, thus NG prices in the toilet.

I'd really hate to additionally bet on a V-shape recovery on top of the structural NG risks I've discussed. There are much more (risk adjusted) profitable bets on a V-shape recovery in the market.

Betting on a V-shape recover is over the top for a NG bet at this point. Also, how can you be so sure that that '06/'07 event (see above) won't repeat in 2010?

In summary, NG prices seem destined to go well under $2 well into November, and while it may rebound next year LNG will keep it near $4 and kill/hurt most US NG producers until the economy fully recovers (1-2 years) and get NG price in the $5-6 range.

So, you can try catching a falling knife or put your money in NG stocks which will collapse next year when there hedges are gone and NG is kept too low b/c of LNG. Seems like NG is a bad bet until at least Nov.

Cheers,
Ariel-

Sep 07 03:27 AM

[Timothy D. ...:]

Ariel,

Intelligent and detailed comment. I don't have time to answer every detail, but the short answer is that you present the sort of scenarios that present a risk to any bullish gas investment at the moment. Particularly if U.S. growth (if any) is anemic, the risks are considerable. And while North American production still dominates the U.S. gas market, one of those risks is that LNG may have sufficient volume to have a real impact on NG at the margins if growth remains weak. Of course, low prices will generally tend to depress LNG, given the non-negligible transport and storage costs. But if, say, some Russian oligarch decides to dump LNG on the U.S. market, that would certainly further crater prices (but why he would want to do such a thing is hard to figure, though).

I also agree with you that some gas companies are more vulnerable, in the medium and longer term, than is gas itself, as their hedging level decays. Overall, I don't dismiss your bearish scenarios at all, but I think the deceleration of U.S. domestic production is not widely priced in by many investors (or even recognized) and is sufficiently important to have a real impact on prices fairly soon, which was why I wrote the article. I think this is likely to have a bullish impact on prices, all else being equal. But as you detail, all else may not be equal. I think there is large uncertainty on the consumption side (as I noted), and you point out that there are still uncertainties on the production side (citing LNG imports especially); both of which means that this is, by no means, a sure thing (rare things, those). If I had to put numbers on it (which I try to do, to optimize my reward/risk as best I can) I would say there is c. 30% probability of more, but probably modest, NG declines from here, but a c.70% probability of increases, and included in the latter is a real possibility of quite rapid price increases, far more than many expect (as they throw in the towel, in many cases). This is an ideal scenario for a levered option play, with known bounded risk, but potentially large returns. But it is no sure thing. As always assess and limit your risk -- unless you have a 100% probability of success, you must limit your downside!

One thought as to rig counts ticking up: it may be a small proportion, but I suspect that some of the activity of late is by producers in tight formations whose production has fallen off so much that they are forced to infill to deliver what they've already hedged.


On Sep 07 03:27 AM Aricool wrote:

> why can't it go under $2? If most of the producers are 100% hedged
> for '09 (hence likely why their stock prices are not in the toilet
> w/ NG price) and they have to produce to keep their valuable leases
> and we have a 100 year supply, then why stop production at any price
> when you're getting top (hedged) $ any how??? Someone needs to explain
> to me why will they given these (and many other simar) factors.
>
>
> Besides, did you notice that rig counts bottomed in early June and
> actually started to uptick in July-Aug. Also, day rates never came
> down enough. Not a good sign if you believe in major production cuts.
>
>
> Also, if you look at the last recessions NG droped to around $2.5-2.7
> in real terms (adjusting for inflation); however, that was when US
> NG production was believed to have peaked, which is why we later
> created infrastructure for LNG imports- and those lows were before
> we became the Saudi-Arabia of NG with massive supplies. So, it would
> stand to reason that we'll see below $2 easy; esp. since we got so
> quickly to $2.5 w/o resistance.
>
> Moreover, I'm very concerned about the long term pricing of NG. I'm
> trying to see it as bullish as you do, but many long-term factors
> seem like it might keep it very low- not the least of which is LNG
> imports from Russia and Arabs when NG gets back over $4.
>
> Have a look at the LNG import spike between end '06 and early '07
> and it tracks *exactly* with a step down of NG price from 7 to 5.
> This is insane that LNG could crush prices during a robust US economy.
> I'm very scared now that with the paltry 2% trend growth expected
> for the US (and EU?) going forward that they'll dump excess Euro
> LNG onto the US and repeat that '06/'07 event. This would almost
> certainly keep NG prices under $4 in the expected weak situation
> for '10. This is a huge uncertainty in playing '09 weakness esp.
> if buying into NG driller/services securities to play the "perfect
> storm" against NG. That is, the LNG would dump just enough supply
> to easily keep the storage full, thus keeping NG exploration and
> cap ex down to a minimum, and b/c most NG producers are only partially
> hedged for 2010 (maybe 30% or less?) then they would get killed in
> 2010 making there hedged supported stock prices 2009 quite high.
> This uncertainty really sucks! Can you discount this scenario?<br/>
>
> the EU is expected to recover more slowly than the US so why (in
> the context of those reports/articles I sent you) won't the LNG plays
> dump what ever they can on the US. As I analyze the charts, the LNG
> chart tells me a very bad story. That is, the June '09 LNG was sold
> at only ~ $4.3 while volumes where a little above that just before
> the '06 event (see above) when NG price in '06 was ~7, and then dumped
> 2X the volume for 6 months and were more than happy to collect only
> $5 in that time. Again, this was when the EU and US were heading
> into a peak earning cycle. This tells me that the LNG players will
> keep US NG prices in the toilet (<$4) until the US (and EU?) are
> in a full recovery. Very, very bad for NG sector stocks for 2010.
> Please debunk this gloom and doom scenario! It seems all too possible
> if the magal V-shape recovery does not materialize in early 2010.
> Hence, why with a weak EU they'll dump there LNG at a (double? june
> '09) high rate and keep the US storage near max, thus NG prices in
> the toilet.
>
> I'd really hate to additionally bet on a V-shape recovery on top
> of the structural NG risks I've discussed. There are much more (risk
> adjusted) profitable bets on a V-shape recovery in the market.<br/>
>
> Betting on a V-shape recover is over the top for a NG bet at this
> point. Also, how can you be so sure that that '06/'07 event (see
> above) won't repeat in 2010?
>
> In summary, NG prices seem destined to go well under $2 well into
> November, and while it may rebound next year LNG will keep it near
> $4 and kill/hurt most US NG producers until the economy fully recovers
> (1-2 years) and get NG price in the $5-6 range.
>
> So, you can try catching a falling knife or put your money in NG
> stocks which will collapse next year when there hedges are gone and
> NG is kept too low b/c of LNG. Seems like NG is a bad bet until
> at least Nov.
>
> Cheers,
> Ariel-
>
>

Sep 07 12:16 PM

[receipt:]

One way to go long natural gas is Horizons BetaPro NYMEX Natural Gas Bull Plus ETF (HZBBF)

Sep 07 01:23 PM

[dmz50:]

piss on the gov.

Sep 07 01:31 PM

[Boffilicious:]

"natural gas energy comes with smaller carbon and pollution footprints"
That all depends on what is being done with the excess Carbon Dioxide when Nat Gas is extracted dried and scrubbed. Norway sequesters it but as I understand the US does not... big, big difference.

Sep 08 04:13 AM

[Mad Hedge F...:]

ortyjm. 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 10:53 AM

[naturallight:]

>>>1. It is the simplest way to seasonally adjust the data,
>>>which is important because there is considerable seasonal
>>>pattern in natural gas production (this seasonal pattern had
>>>been less pronounced lately, but it is still significant).


Umm, what? Natural gas production exhibits virtually NO seasonality. Here is U.S. Dry Natural Gas Production (bcf/d) by month since Jan-1997. The difference between the biggest month (March) and the smallest month (September) is only 4.4%. Furthermore, I’m fairly sure this is explained by the effects of large hurricanes, which is not really “seasonality”.

Jan 52.6
Feb 52.6
Mar 53.2
Apr 52.7
May 52.7
Jun 52.9
Jul 52.2
Aug 52.2
Sep 50.8
Oct 51.6
Nov 52.1
Dec 52.1

Sep 08 05:37 PM

[Boffilicious:]

I think you are posting the wrong chart: It is the dry production chart that is more appropriate (marketed production less extraction loss) - see:
tonto.eia.doe.gov/dnav...
The figures you are using include gas used in extraction (ie returned to reservoir,) also carbon dioxide, water and non-gas contaminants and so on.
For ten years 1998 - 2008 dry production swung between 1.5 and 1.7 quadrillion cu feet per month declining to 1.5 to 1.6 per month in the years 2004 to 2008 but rising to 1.6 to 1.8 in 2008 to present.
This compares with consumption swinging between 1.5 (summer) and 2.5 (winter). The balance comprising about .25 per month was made up by imports from Canada and of LNG.
www.eia.doe.gov/pub/oi...
Shows this clearly. Whilst I understand your notion of looking at the rate of change of increase however, in a time of collapsing industrial demand and negligible spare storage or pipeline capacity, I think it ludicrous to imply that a slowing increase in production (as more expensive production is closed - hence collapse of rig counts) implies future pressure of shortage of supply.
Strange also that your article makes no mention of Quatar, of Canada, of deep well production... no mention of the collapse of European demand which led to prices at close to zero in the UK. https://theice.com/productguid... no mention of LNG imports/exports and no mention of demand figures.

It really does not really matter if supply is dropping if supply still exceeds demand and there is no storage which is clearly the case.
I recommend this piece in Time which explains it well:
www.time.com/time/busi...

Sep 09 02:38 PM