This winter is a harsh one in the U.S. At the beginning of January, a massive cold wave (which actually started in December) swept across the country. It was so bad, this cold wave even got its own Wikipedia article. On January 5, the temperature in Green Bay, Wisconsin was -18°F, the coldest temperature recorded since 1979. Chicago saw the temperature dive to -16°F, the lowest temperature since 1884, which was matched only once before, in 1988. Luckily, I live in warm Israel, where if the temperature drops to the low 50s - high 40s, it's considered to be a horrible winter.
By now, you are probably wondering, why am I reading about the weather in Seeking Alpha? I believe that a few factors (including extreme winter) kicking in just about now are supporting high natural gas prices in the U.S. (Henry hub prices). These high gas prices can dramatically improve natural gas drillers' profitability. Let's go through the events that are just now kicking in.
Natural Gas Inventory
Natural gas inventory in the U.S. is monitored weekly by the Energy Information Administration (EIA). Back in 2008, when the run to exploit huge reserves of natural gas in the U.S. was underway, natural gas prices took a dive. From the high of June 2008 of $12.69 per mbtu, prices went down to as low as $1.95 in April 2012. At this price, most drillers were selling gas at a price point that was below their cost, thus bleeding money. The strategic decision of most drillers was, to start drilling more oil, and less gas.
These are the gas inventories of the U.S. lower 48 states. You can see that when prices hit an all-time low in April 2012, there was a huge oversupply of gas in the market. Drillers rushed to cease drilling new gas wells and moved their emphasis to liquid drilling. Although actual gas production stayed constant and even went up a bit, two harsh winters have done their job. During the 2012-2013 winter, the inventory returned to normal levels, and even crossed the 5-year average line. This winter, the inventory level dived under the 5-year minimum level, signaling that the inventory level has reached an extreme low. As of this week, the gas in storage in the U.S. is 637 bcf under last year's figure, and 437 bcf under the 5-year average. The lowest level in the last 5 years for this week was 153 bcf more than the actual data posted by the EIA last Friday. If this trend continues, this should support current prices and even a higher level.
U.S. Gas Rigs' Activity
When the majority of drillers decided to move their resources to liquid drilling, the number of rigs drilling for gas took a dive as well. From the high of 1585 rigs active as of September 2008, there were only 366 rigs active in November 2013.
This data point is tricky. While the number of rigs went down, actual production went up.
This could mean one of two things:
- Each gas well produced more gas to such a degree that it offset the decline in number of gas wells.
- The increase in oil wells brings a byproduct, natural gas that originates from an oil well. Capturing that gas pushes the market production up.
I suspect that a combination of the two factors is at work here. A recent article by NPR is estimating that in North Dakota, which lacks the pipeline infrastructure needed to transport natural gas, more than $1M worth of gas is wasted (burned) each day. This is a remarkable figure, and shows that the drillers are so much focused on the oil side of their wells, they just prefer throwing away the natural gas that comes up along with the oil. In the same article, Marcus Stewart, an energy analyst with Bentak Energy, estimates that about 27% of the produced gas in North Dakota is burned. After weighing everything in, it looks like the production of gas is still on the rise but slowing down. When sudden demand next hits the U.S. natural gas market, the drillers, who are currently operating only 366 rigs in the country, will be caught with their pants down.
U.S. Natural Gas Export
We are getting close to the start of large-scale natural gas export from the U.S. It is clear that the current production and gas in storage is not even close to sufficing to meet the huge demand that new export facilities will bring. The natural gas export initiative, which will happen in the form of LNG exports, has the potential of reaching an export rate of 18.2 bcf per day, as is demonstrated in the following Department of Energy (DOE) slide:
Current consumption of natural gas in the U.S is ~69 bcf per day. When fully realized, the export imitative can increase demand to ~87 bcf per day, or an increase of about 26%. I believe that this rise in demand will not meet the equivalent rise in supply, thus forcing prices up. The laws of arbitrage tell us that when export volumes ramp up, the price environment around the world will be more uniform. As the cheapest provider of natural gas in the world, the U.S. will see increased prices as more and more demand will flow from Asia.
Natural Gas Futures
Natural gas futures show a very positive picture for gas drillers. The gas companies can lock in prices north of $4.5 per mcf of natural gas for 2014. After 8-9 quarters during which companies like Chesapeake (CHK) realized an average selling price for natural gas in the $2.5 per Mcf neighborhood, the current price environment could offer substantial profitability and revenues improvements as ASP increases (after the companies work their way through their old contracts). According to Chesapeake's last earning call, it locked a price of $4.23/Mcf for about 233.6 Bcf in 2014. That represents about 20% of Chesapeake's annual gas production. Taking a look at the Henry Hub futures, I believe Chesapeake can further leverage the price environment to enjoy favorable margins on natural gas sales. Just to demonstrate this ASP increase effect on the financials, if Chesapeake would have sold all of the natural gas it produced in 2012 (1128.8 bcf) at $4.5/Mcf, it would have made over $5B in natural gas revenues in comparison to the actual $2B it made. In 2013, I expect that Chesapeake will have made $2.5B on 1085 bcf of natural gas. Assuming that Chesapeake gas production in 2014 will be 1050 bcf, in theory, it could make $4.7B if it manages to sell all of the gas produced at $4.5/Mcf on average.
Henry Hub Futures
Source: CME Group Henry Hub Futures
In conclusion, I believe that with the three factors I have mentioned in play, gas drillers could soon see an increase in their revenues and profitability. I believe the facts support natural gas prices north of $4.5 per Mcf for the coming years. This will benefit companies like Chesapeake Energy, Ultra Petroleum (UPL), Devon Energy (DVN), and others. As LNG export facilities go online in the next few years, the added demand can push prices even higher, and the days of sub $4 gas prices could well be behind us.