Investors in coal (KOL) and natural gas (UNG) sectors watch supply and demand in U.S. natural gas (or NG) closely. The over-supply of NG resulted in decade-low NG prices and suppressed coal prices as well, as some coal demand in the power sector switched to NG.
People believe that as the current NG price is far below profitability, NG producers would slow down well drilling and curtail production. That happens in every sector: if producers cannot make profits, they must either cut productions or ultimately go out of business.
US Coal Production Was Curtailed
Early in 2012, US coal producers vowed to cut production. The EIA Weekly Coal Productions did show a massive production curtailment:
But are NG producers curtailing their productions? So far there is little evidence of NG production curtailment in EIA data.
Are NG Producers Curtailing Production?
NG producers like Chesapeake (CHK) and EnCana (ECA) did vow to curtail production, while Southwest Energy (SWN) continues to grow. But the data shows little curtailment. (See NGSA's daily production data of top 40 producers for Q1 and Q2.) From Q3-2011 to Q2-2012, the combined daily productions of these producers were 34.373, 34.125 and 33.722 BCF/day. The drops were unremarkable.
Producers did reduce drilling rigs for dry gas remarkably. Meanwhile they also increased rigs targeting oil/liquid rich wells. Some people speculate that the increased by-product gas production from the oil wells may have partly balanced the reduction in dry gas production.
Even Mr. Aubrey McClendon, CEO of CHK, was puzzled by the data as he disagreed with models that show little production declines:
Given that Chesapeake produces 10% of the natural gas in the U.S. and has been responsible for 35% of the gas production growth over the past few years, we find it hard to model natural gas production growth when we're going to decline 7%. (Note: 10% is for CHK gross operated productions, after deducing interests of partners and royalties, the portion of production that CHK owns is 3 BCF/day, or 4.5% of US total)
I decided to scrutinize the NG production data to find out the truth.
Different NG Production Numbers
I believe that monitoring the raw data of gross withdrawal from the wells is more accurate in telling the real trend of production decline. Let me plot out the data of both the gross withdrawals and the dry productions, as well as a percentage ratio of the two:
The above is the chart of NG daily gross withdrawals. It shows a clear decline in 2012 due to reduced drilling.
The above is the dry production, which people watch more closely. The decline in 2012 is much less clear. It looks more like a flat line.
The percentages of dry productions divided by gross withdrawals, as shown above, tells the real story of the seeming flat dry production.
As shown, the percentage changes seasonally. The percentages are lower in winter months, meaning you get less dry production for the same amount of gross withdrawal. But in the summer, especially in July and August, the percentages are higher.
The seasonal change suggests it is probably related to temperature. I have an explanation. The gas comes from deep underground where the temperature is higher. For each 1km depth, the temperature goes up by 25°C. When the gas first comes out, the volume of the gas measures higher because the gas is hot. As it cools down to ground temperature after initial processing, the volume is lower. The first volume measured is the gross withdrawal number. The second measurement, after the processing, is the dry production.
Assuming the average temperature is 26°C in the summer and 12°C in the winter, the volume of the gas would expand by 4.9% in the summer versus the winter. In 2011, the dry production percentage went from 79.2% to 83%, up 4.8%. That matches my estimate.
Conclusion and Implication to Investors
The conclusion is that the dry production number is probably biased by the fluctuation of the ground temperature, thus it is not a good indicator of the actual production decline. The number is bloated in the summer due to higher ground temperature.
My suspicion is supported by the fact that NG turbines seem to run at less energy efficiency in the summer than in the winter. See column M in the data table in my previous article. The NG turbines work just fine, but there is 5% less gas in each cubic feet of volume as the temperature is higher in the summer versus the winter.
The seasonal change, as I have shown, is as much as 5%. The 5% is NOT pocket change. At 480 BCF/week NG supply, a 5% bias in the data means the difference of 24 BCF in weekly storage injection. Investors would freak out when their projections were off by 2 BCF when the number is released by EIA on each Thursday.
So we should watch the gross withdrawal numbers for a better sign of NG production decline. From January to June of 2012, the gross withdrawal dropped by 2.723%. Annualized, the drop rate was 6.4%. That is quite significant.
Moreover, as seen in the chart, the gross withdrawal has gone from rapid growth from July to November of 2011, to steady decline from January to June of 2012. So there is real NG production being cut.
Things are looking good for the investors in the coal and NG sectors. The current coal price is just around the threshold of profitability for coal producers. But the current NG price is way below cost for NG producers.
As I emphasized repeatedly, investors should opt for coal producers, not NG producers. Coal is as important as NG for America's energy needs. Annual U.S. production of coal and NG contains roughly equal amounts of energy. However, the investment community gives more than $700B of market capital to the top 40 U.S. NG producers that are responsible for only 38% of U.S. NG production.
Meanwhile, eight U.S. coal producers that are responsible for more than 2/3 of U.S. coal production are given only $16.44B of market capital. Investors have lopsided on NG vs. coal by a ratio of 75 to 1. This is one of the biggest investment mis-allocations in history.
The eight US coal producers are: Peabody Energy (BTU), Alpha Natural Resources (ANR), Arch Coal (ACI), Cloud Peak Energy (CLD), James River Coal (JRCC), Walter Energy (WLT), Alliance Resources Operating Partners (ARLP) and Patriot Coal(PCXCQ.OB). I continue to urge people to invest in these great values in coal.