Natural Gas Likely To See $5 Within 2 Years

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Includes: CHK, D, LNG, XOM
by: Darian Frost

Summary

Natural gas was produced largely as a by-product of shale oil production.

As domestic oil investment halts, supply of natural gas in the U.S. will fall.

Using Burner-Tip parity, we find that electrical plant operators will not stop demanding natural gas as fuel until it gets too expensive at $5-6 per million btu.

All this even as OPEC and non-OPEC countries make a deal to freeze production at record high levels.

Natural gas prices in the United States have hovered around $2-3 for months now. As crude prices have nosedived, many traders have taken that as a cue to take natural gas further down as well. I believe this thinking to be flawed, and that natural gas prices will rebound over the next year to $4-6 per million btu. Here is why.

What has been driving Natural Gas below $3?

In the 1990s, the prevailing pricing mechanism for natural gas was a 10-1 relationship to WTI oil. This meant that for $50 per barrel, the appropriate natural gas price would be $5 per million btu. This was not so much a hard and fast relationship, more of a rule of thumb. Recently, however, the spread has been more 20-1 than 10-1. Market analysts were convinced that the link between crude oil and natural gas was being strained beyond repair, and that there is no ratio at all.

I disagree with the assertion that there is no link between these two commodities. I also disagree with the existence of the ratio if that ratio is massive like 20-1. Instead, I believe a different ratio is more economically sound when comparing these prices. The burner-tip ratio currently stands at 6-1 and is computed based on the heat content of residual fuel oil vs. natural gas. I will explain this further in another section.

The problem is the ratio had been stretched by technological advances in shale drilling. While crude oil was at its highs of $80-100 per barrel, shale drillers were drilling like crazy. With breakeven costs approaching $50-60 per barrel, they were making a good profit. Where does natural gas come in all this? The same wells that produce shale oil also produce a lot of lighter hydrocarbons like methane. Essentially, shale drilling for oil was also producing natural gas. Instead of burning off the natural gas, they decided to sell it on the open market and get any price it would fetch.

Electricity Generation by Source Click to enlarge

The by-product production of natural gas allowed it to be produced much cheaper than natural gas-only wells would have produced it, and created a national supply glut for natural gas that has persisted for many years. It is this supply glut that has expedited the conversion of much of the industrial and electrical residual fuel oil customers to natural gas.

Natural Gas Will Return to the Burner-Tip Ratio

In the 90s, natural gas prices were driven by demand. The 10-1 ratio was a psychological level that buyers were not willing to allow themselves to cross to the upside, but it was still a great idea to switch over to natural gas due to the environmental and competitive pricing benefits. In the early 2000s, the price of natural gas got more competitive, and the Combined Cycle Gas turbine became more prolific. It became economic to burn residual fuel oil or natural gas and to switch between them based on the price per energy unit. This is where burner-tip became a relevant pricing philosophy.

The energy content of a barrel of crude oil is approximately 5.8 million btu per barrel. Power plants and industrial users can use a more refined energy source like residual fuel oil instead of natural gas. Residual fuel oil is generally priced at 95% of WTI crude prices, and contain 6.28 million btu. In modern fossil fuel burners, plant operators can switch between fuels based whichever commodity is cheaper. This energy differential is the basis of the theory of the burner-tip ratio, since the cheaper of the two commodities based on this ratio will gradually gain more demand as operators switch from the more expensive commodity.

This ratio may not represent a short-run arbitrage opportunity, but it does represent a long-term upper limit to the price of natural gas. At current crude prices, this suggests the long-term level at which substitution of fuels will start eroding demand is at $5-6 per million btu.

Lack of Supply Will Push Prices to the Upper Limit

Why is it important that we calculate the upper limit to natural gas prices? Because recent market developments concerning international crude oil production and prices have major impacts on the production and prices of domestic natural gas. As I explained previously in this article, shale oil formations routinely produce both oil and natural gas. With high oil prices, it was economic to produce both commodities. The price of oil more than made up for the low prices natural gas would fetch.

During this time, the innovation of shale gas production caused supply to drive the market for years. So while crude oil had always been demand driven while it was high, the consequence was that markets for natural gas became supply driven. Now that crude oil prices have dropped so dramatically, production of crude oil will adjust to compensate. The effect on the natural gas market will severely reduce supply as new investment in both oil and gas stalls to a standstill.

Natural Gas Well Completions

This coming trend is further supported by figures from BTUanalytics, a data service catering to energy investors interested in natural gas. Recent data suggests next to no new wells were completed this year. As the chart suggests, this decline in well completions coincides with the drop in crude oil prices starting when Saudi Arabia and other OPEC members turned on the taps at full capacity and never stopped.

Typical Shale Oil Well Production Decline

If the lack of completions were in crude oil wells, it would be significantly less alarming since the production decline is far less dramatic. However, a crucial aspect of natural gas wells is the rapid deterioration in gas production in the first few years of operation. Many sources agree that wells producing natural gas lose approximately 65% of annual production within the first few years.

Supply and Demand

As supply of natural gas begins to dwindle due to a lack of future investment in wells, the demand will continue until the burner-tip parity ratio is met. Here is a review of the factors likely to influence natural gas prices, and the levels at which they become relevant.

Current natural gas prices stand around $2 per million btu. I have read that breakeven for natural gas-only producers is around $4 per million btu. We shouldn't see new supply come online until crude oil moves past $40-50 per barrel on the upside, at which time hybrid wells could be completed, or natural gas itself moves above $4 per million btu. With declining supply, buyers will continue to exert upward pressure until it is cheaper for major consumers to switch to something cheaper. With current crude prices, the level at which buyers would switch to residual fuel oil is 1/6 the price of a barrel of oil ($30 barrel equates to $5 per million btu of natural gas). Buyers don't start substituting until $5 per million btu, which is my price target for natural gas.

Conditions that would cause an invalidation of my theory include higher oil prices and more advanced (cheaper) technology for gas extraction. Higher crude oil prices impact my theory negatively because at higher oil prices domestic producers will resume oil and gas production, and supply will resume driving the markets. If new technology is pioneered that reduces the breakeven price of producing natural gas to $2-3 per million btu, domestic producers of natural gas will resume before reaching the $4 per million btu level.

As always, do your research before investing in any idea. I will continue to cover the evolution of this theory as markets change, but the contents of this theory have major implications to the following firms:

  • Cheniere Energy (NYSEMKT:LNG)
  • Dominion Resources (NYSE:D)
  • Chesapeake Energy (NYSE:CHK)
  • Exxon Mobil (NYSE:XOM)

Other companies impacted by this development include pipeline operators, natural gas drillers, and utilities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.