Marcellus Region Producing 12 Bcf/D, According To EIA Report

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In a new study titled "Drilling Productivity Report," which was released by the Energy Information Administration last week, the agency provides a valuable set of aggregated production and drilling data for several major shale gas and "tight oil" producing areas in the U.S. The report focuses on six broadly defined regions: the Bakken, Eagle Ford, Permian, Niobrara, Marcellus, and Haynesville (the map below) and summarizes both crude oil and natural gas production data for each region.

(Source: EIA, October 2013)

On the natural gas side, the report illustrates the most powerful trend that has defined the dynamics within the North American natural gas market in the past three years: the meteoric rise of production volumes from the U.S. Northeast, which has led to forced displacement of traditional import inflows into the region from other higher-cost sources. The report shows that the Marcellus production volumes have grown at essentially constant pace over the past three years and have just crossed over the 12 Bcf/d mark (November 2013 volumes are expected to increase by another 408 MMcf/d).

(Source: EIA, October 2013)

It is important to note that in this specific study EIA takes a geographic rather than geologic approach to categorizing production and drilling activity: all formations and well types appear to be included in the total volumes (e.g., as visible from the graph above, production data for the "Marcellus" include pre-Marcellus production from legacy vertical wells). As a result, the EIA's aggregate production figures may differ from those provided by other surveys. The important metric that should be invariant, however, is the incremental production volumes from the region (which have been dominated by the Marcellus Shale formation in the past four-five years).

The graph above indicates that the Marcellus region (which in EIA's categorization includes Pennsylvania, all of West Virginia, and select counties of New York and Ohio) has added approximately 3 Bcf/d of incremental natural gas volumes in each of the past three years and no slowdown is detectable in the most recent data.

Production growth in the Marcellus has displaced volumes in other dry gas shales characterized by higher cost of supply, such as the Haynesville Shale. EIA's report shows a steep decline trend in production from the Haynesville region since the peak reached at the end of 2011 (graph below).

(Source: EIA, October 2013)

The report also shows that continued production growth in the Marcellus has been achieved with a steadily declining number of drilling rigs (the region's rig count has declined from its peak of ~150 rigs at the end of 2011 to less than 100 rigs currently - the graph below). The result is particularly impressive given the dramatically increased weight of the liquids-rich portion of the play where wells tend to have substantially lower dry gas yields compared to sweet spots in dry gas areas.

(Source: EIA, October 2013)

The biggest question of course remains: how long can the Marcellus sustain its steep growth trajectory? The region may continue to surprise skeptics with its unabated pace of growth for several more years. One important underpinning driver is the economically-advantaged location of the Marcellus and Utica in the heart of the consuming region. The newly established Northeast Producing Region is not only characterized by the exceptional productivity of its sweet spots and low development costs, but also has the proximity advantage relative to the destination markets in the Northeast/New England, Mid-Atlantic, Midwest, and East Canada.

The second important factor is the highly effective North American long-haul transportation network for natural gas that offers tremendous flexibility of delivering the commodity to consumers at distant locations at very low cost. Pipeline operators have already demonstrated their ability to adapt to the new inter-regional supply balance by quickly reversing flows on certain trunk pipeline segments and addressing bottlenecks (developments at REX pipeline is perhaps the most striking recent example). The trend will without doubt continue. In fact, the Northeast's newly found self sufficiency in natural gas has effectively created spare capacity on the national pipeline network, which puts pressure on pipeline operators to offer value-added transportation solutions so that the utility (and profitability) of the legacy transportation system is maximized in the new environment.

As the Northeast increasingly plays the role of natural gas exporting region, a negative differential to other regional price points must develop. The differential may experience sharp spikes during the transition period. However, once pipeline flows find a new inter-regional equilibrium, the differential is unlikely to stay wide: the availability of several major underutilized trunk pipelines that can provide low-cost transportation solutions for the Marcellus and Utica gas should ultimately translate into fairly uniform pricing across the nation's key pricing points.

The actual results in the Marcellus show how hopelessly off the mark many forecasters have been in their predictions of the region's production trajectory. To provide just one example, Wood MacKenzie's forecast from May of last year missed on the 2013 volumes by a wide margin. At the long end, the forecast projected the Northeast's total supply to reach ~16 Bcf/d by 2020 (graph below), which in retrospect from today is an unrealistically low scenario. Notably, the forecast represented a substantial increase from the firm's earlier forecasts, as analysts were scrambling to catch up with the actual numbers from the Marcellus.

(Source: Wood MacKenzie, May 2012)

Wood MacKenzie's forecast from just a year later appears to be adjusted upward at the long end by another 1.2-1.5 Bcf/d (Spring 2013 Outlook quoted on the slide from Dominion's latest presentation, below).

(Source: Dominion, September 24, 2013 Investor Presentation)

However, the updated forecast is already obsolete in terms of its estimated 2013 exit volumes. At its longer end, the forecast also appears too low and is likely captive to an old-paradigm mentality unable to anticipate the magnitude and pace of improvement in completion techniques and work flow optimization that have already delivered massive productivity gains in the Marcellus and amplified the region's cost advantage over many other producing areas. The forecast may also prove to understate the productive potential of the Utica, another giant awakening at the Marcellus's side.

The most important consequence of the Northeast's continued rapid production growth is the irreversible decline in natural gas pricing. Supporters of the view that the current natural gas prices represent a cyclical aberration that will soon correct themselves are still many (the natural gas futures curve has supported such view until very recently). However, actual Marcellus operating data is every day reinforcing the opposite view. The supply is ample, well productivity is continuing to improve rapidly, and gas transportation systems is more flexible than skeptic's perception of it. Natural gas prices in the $4.00/MMBtu range are secular and are likely to stay for some time.

Due to the sheer magnitude of incremental annual volumes from the Northeast, the Marcellus and Utica increasingly displace higher-cost areas such as the Haynesville as new marginal sources of supply. Price for natural gas will be increasingly set by break-even economics in areas that until recently had been considered "baseload" (such as Marcellus's Tier 1 dry gas areas with typical EURs of 6-8 Bcf per 5,000 lateral and well costs in the $6 million range, where current drilling activity is slow). While it is debatable if those areas truly "work" in a $4.00/MMBtu Nymex environment (which makes them the price-setters), $5.00/MMBtu price is certainly ample for highly economic development and therefore is way too high to be the equilibrium price.

The implications are relevant to gas-oriented E&P stocks and natural gas ETFs such as United States Natural Gas Fund (NYSEARCA:UNG).

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