This question, which was very much on analysts' minds at the beginning of this year, has suddenly resurfaced. It is an issue which could have profound effects on the price of natural gas and on the companies that produce it. Investors in the Natural Gas ETF (NYSEARCA:UNG), and in producers with significant natural gas exposure such as Anadarko (NYSE:APC), Chesapeake (NYSE:CHK), Encana (NYSE:ECA), Exco (NYSE:XCO), Cabot Oil and Gas (NYSE:COG) and Ultra Petroleum (NYSE:UPL) will be impacted by this issue.
The Maximum Storage Case
Natural gas is stored in underground structures. Producers extract natural gas from wells all over North America, and then pipe it to various storage sites distributed around the continent. From the storage sites, it is then shipped to the markets where it is consumed. There is a finite amount of gas that can be held in storage. The EIA estimates that the maximum amount of gas that can be stored in the lower 48 states is 4,049 bcf. Maximum storage has become an issue because new technologies of hydraulic fracking and horizontal drilling allowed shale gas to be recovered, creating significant new supplies. 2011's mild winter caused less heating demand and consumption dropped. Together, these two effects combined to create a significant glut of natural gas, as further explained in the opening paragraphs of this article. This year, we began the injection season (the period between March and October where production exceeds consumption) with working gas in storage significantly above the 5-year average. That caused many to believe that normal injections into storage, on top of that bloated opening inventory, would lead to maximum storage capacity being exceeded.
A Review of the Numbers
We began injection season with 2,386 bcf of gas in storage, 54% above the 5-year average. The average inventory build during injection season for the last five years has been 2,127 bcf. Therefore, an average year would take us up to roughly 4,500 bcf, well above storage capacity. Through 2011, production had been increasing. In 2011, 2,213 bcf was added to storage, which at that rate, would take us to almost 4,600 bcf. In fact, had we injected at the 5-year average rate, maximum capacity should be reached by week 37 (three weeks from the date this article was written).
But the reality is that we have not been injecting at the 5-year average rate. In fact, so far this year, we have injected 1,005 bcf into storage. That compares to the 5-year average for this point in the year of 1,464 bcf. Since the beginning of injection season, we have been running at 31% less than the 5 year average. The reduction in the rate of injection can be attributed to a significant decline in the natural gas active rig count, currently at 486 rigs, down from 898 a year ago, as well as the steep decline rate on shale wells. If we maintain the pace of injection at 31% less than the 5-year average, we should inject another 455 bcf during this season, and hitting peak inventory of 3,829 bcf. This number is 200 bcf below maximum and 142 bcf above the 5-year average. At this point, the numbers indicate that natural gas maximum storage capacity will not be reached this injection season.
Beyond The Numbers
While a statistical review is helpful and is objective, I think that value can be added to that review by looking at a one of the qualitative factors as well. We need to be cognizant that numbers become the after-the-fact result of management decisions. Maximum capacity could be reached if producers were to make a conscious decision to increase production. Certainly comments in the press and discussions on quarterly conference calls of major producers would indicate that is not happening. Production is being curtailed, and this is most evident in the precipitous decline in the rig count. Keep in mind that there is not a direct, one-to-one correlation between rig count and production. A rig can drill a well in a matter of weeks; that well can continue to produce for years. Natural gas production has been steadily rising for years, but in 2012, we have actually seen a small reduction in monthly production, with May's gross withdrawals still slightly below January's. With natural gas prices well below full cycle costs of production, rational producers are unlikely to increase the rig count and take production levels back up to where they could breach the amount of maximum storage. Reviewing both the numbers and the behavior of producers, I am led to conclude that maximum capacity will not be reached this year.