Speaking at an industry conference in New York on September 6, Southwestern Energy's (SWN) CEO Steven Mueller, answering investors' questions, shared his view on the natural gas industry fundamentals and future direction of gas prices. Mr. Mueller's perspective is particularly interesting as it comes from the CEO of a leading pure play natural gas producer whose operated volumes represent over 3% of total U.S. natural gas supply.
With regard to the natural gas production trend, Steven Mueller commented:
"As I look at it in the future, generally I think production is going to stubbornly stay high for the next twelve to eighteen months. I don't see much dip in the production. It has started to flatten out, and will stay pretty much flat for a while, before you actually see it tip over."
On the demand side, he sees no sources of additional demand that would help turn around the over-supplied situation in the domestic natural gas market in the immediate term:
"For the next twelve months - all the demand, all the things you can use gas for, is being used today - so you will not see much more demand. Demand is approaching though that flattened production line, so it will continue to go towards that line."
Looking beyond the twelve- to eighteen-month time frame, Steven Mueller sees a substantial step up in the end-user demand as additional gas-fired electric generation capacity starts coming online and consumption increases in the chemical, steel and other industrial sectors.
"As you go into 2014 though, there has already been significant decisions made, especially on the gas plants versus coal plants, that you are going to start seeing demand come in on the gas [-fired generation] side. And so I can see steepening demand in 2014, and you don't have to have a supply response necessarily, as long as it stays roughly flat, to get back to balance. And to give a perspective on that, last year there is a little over 1 Bcf/d of decisions made to build gas plants over coal plants. Those will start coming on with about a two-year lag, so will start coming on in the end of 2013 and into 2014. This year, already 1.8 Bcf/d of decisions for new gas plants have been made. And if you look at public utility dockets, there is about 2 Bcf/d that will be made over the next twelve months, and I think about 1 Bcf/d will be made towards gas plants. So you have 4 Bcf/d demand increase just on [the natural gas-fired generation] side of it. And then there is 700-800 MMcf/d in announced new manufacturing plants, whether it's Dow Chemical or US Steel or Nucor... So I can see over the next four years 5 Bcf/d increase. We have a 2 Bcf/d problem today. So as long as the production flattens out a little bit, by the time you get into 2014, you will start getting supply and demand back together."
Commenting with regard to the sustainable price range for natural gas, Mr. Mueller said:
"And what is that number that gets [supply and demand] back together? It's somewhere between $4 and $5 [per MMBtu], in our minds. Once you get above $5, we proved in 2007 we would put 1,400 rigs to work. Once it's below $4, we've proved just in the last eight months that you are going to drop a lot of rigs. And when you are between $4 and $5, people like me staying up here [presenting at the conference], didn't talk much about price. We talked about growing production, or we talked about holding acreage, or some other things. So the industry seems to be agnostic in the $4 to $5 range. And we'll definitely add too many rigs if it starts approaching $5 or get above $5. So I think it's $4 to $5, and we will work hard in the mid-$4 couple years out hedging. We always like to be 50% hedged."
Mr. Mueller's forecast, while not bullish at the first glance, in fact has positive implications for the sector. I would argue, with natural gas prices in the $4-$5 range, the industry stands to make ample returns, and additional demand would amplify profitable volumes.
It is difficult to disagree with Mr. Mueller's assessment that a $5/MMBtu price would not be sustainable for long, considering the industry's much evolved cost structure. Over the past several years, shale gas operators have made great progress in perfecting extraction techniques, reducing drilling and completion times, and optimizing production regimes. On average, natural gas wells are more productive and less expensive to drill and complete than just two or three years ago. Processing and delivery infrastructure has largely been put in place to accommodate massive shale gas volumes.
What is debatable in my opinion, is Mr. Mueller's view that $4 is required to enable stable supply. It is true that the industry "dropped" a lot of rigs earlier this year once natural gas futures decisively moved below $4. However the industry has not dropped production. The Lower 48 natural gas withdrawals have stayed essentially flat from November last year through June this year (latest EIA data available). Moreover, operators with best dry gas assets and lowest costs (including Southwestern) have continued to grow production even as natural gas prices fell close to $2/MMBtu. Cabot Oil & Gas (COG), the operator of highly productive Marcellus acreage, will likely see a 40%-50% year-on-year production increase (mostly dry gas) this year and possibly a similar increase in 2013. Southwestern itself has a three-year inventory of wells in the Fayetteville shale that would be economic at $3 NYMEX; and in the Marcellus, SWN's acreage yields even better returns. The list of examples can go on.
The key factor explaining the industry's resilience in the face of the seemingly very low natural gas prices is the sizable (and growing) inventory of "sweet spot" drilling locations existing across multiple basins and owned by a broad group of producers. Those "sweet spots" require a substantially lower minimum price to provide a solid return on new investment than average wells. Volume-wise, the sweet spots are so prolific that the competition is in fact "sweet spot on sweet spot" (as opposed to "shale on shale"). At $4, many of such sweet spots would yield returns that are comparable to the horizontal oil plays. At $5, the universe of economically attractive drilling locations expands dramatically threatening with an imminent production glut.
Natural gas prices are highly volatile, and it is probable that once the U.S. gas volumes register first tangible declines, prices will spike above the $4 level, or possibly higher, effectively sending a signal to operators that additional rigs need be put to work in dry gas. However, the initial incentive would soon need to be replaced with a "containment" price environment to keep the potentially vigorous supply response from the highly fragmented industry in check. I would argue, the "containment" price is below $4/MMBtu. Expecting that the industry would show capital restraint without harsh price signals would be without merit. As Mr. Mueller stated during his presentation:
"Our industry is a very fragmented industry, and so there is always the chance that, as the industry, we do something crazy when it all sums up, even though for each individual company it makes a lot of sense to do that. And adding rigs in a low gas price environment is one of those things that you always have to worry about as you think about the future."
SWN's comments have high relevance for natural gas focused stocks. My natural gas producer index includes: Chesapeake Energy (CHK), Encana Corporation (ECA), Devon Energy (DVN), Southwestern Energy, Ultra Petroleum, EXCO Resources (XCO), WPX Energy (WPX), Cabot Oil & Gas, Range Resources (RRC), QEP Resources (QEP), Quicksilver Resources (KWK), and Forest Oil (FST).