Natural Gas: Clean Fuel with a Dirty Little Secret

The natural gas market has a dirty little secret: The U.S. natural gas market is currently massively oversupplied. We believe that E&P companies know this, with Goodrich Petroleum (GDP), XTO Energy (XTO), Cabot Oil and Gas Corp (COG) and Chesapeake Energy (CHK) coming to public markets in recent weeks to raise capital in the face of near-record natural gas prices.

The dirty secret is not obvious, until you spend some time with the data. While natural gas demand is expected to increase by 1.42% in 2008, from 65.42 BCF/d to 66.35 BCF/d, domestic natural gas supply increased from 52.97 BCF/d in May 2007 to 57.14 BCF/d in May 2008! This is a stunning 4.17 BCF/d supply response in the midst of a .93 BCF/d increase in demand. The natural gas markets are currently 3.24 BCF a day oversupplied!

Despite the massive growth in natural gas supply, the amount of natural gas in storage began the year 358 BCF lower than in 2007 and today is only 367 BCF lower. How can the market be massively oversupplied when storage levels are constant versus 2007? There were 152 days from January 1 to May 30. If the market was truly oversupplied by 3.24 BCF/d, we should have seen storage increase by 492 BCF. Where did nearly 500 BCF disappear to?

LNG imports have decreased significantly. From January 1 to May 30, 2007 the United States imported an estimated 377 BCF of LNG, in total. During the same time period in 2008, imports totaled 139 BCF of LNG - a level our research shows to be near the absolute minimum contracted levels. The lack of LNG imports has benefited natural gas storage levels to the tune of 238 BCF so far in 2008. This will become apparent in the headline storage data shortly.

We are currently comparing monthly LNG imports of 3.04 BCF/d in May 2007 to 1.02 BCF/d in May 2008, providing a 61 BCF per month benefit to YOY storage levels. LNG imports declined sharply after August of last year. After importing 2.82 BCF/d in August of 2007, the U.S. imported only 1.39 BCF/d in September, 1.03 BCF/d in October and .67 BCF/d by December. Natural gas inventory levels from September onwards will increase by 60-72 BCF per month YOY due to the easier comparisons versus 2007.

A major source of ‘hidden demand’ this year has been increased exports of natural gas to Mexico and Canada. Exports to Mexico have increased from .627 BCF/d in the first four months of 2007 to 1.27 BCF/d in the same period in 2008. Exports to Canada have increased from 235,375 MCF (1.96 BCF/d) in the same period in 2007 to 385,752 (3.21 BCF/d) in 2008, an increase of 1.25 BCF/d.

Attacks on Mexican gas pipelines in July 2007 caused some damage, but were quickly repaired. Six blasts in early September hit pipelines in the Gulf coast state of Veracruz, causing further damage and increasing demand for imported natural gas. The expected startup of the Energia Costa Azul project, which has their natural gas capacity fully contracted, recently occurred as they announced that they were ready to begin commercial operations on May 15. Half of the incoming gas will be marketed by Sempra and half by Shell.

By the second half of the year, this project will bring in .21 BCF/d of natural gas to Sempra. The Mexican Secretaria De Energia expects that Mexican natural gas imports from the United States will be equal in 2008 versus 2007, before declining by 17.34% in 2009 as Mexican LNG imports increase. Exports to Mexico have increased natural gas demand versus by 96 BCF through April 30, 2008. In Canada, despite natural gas production declining by over .50 BCF/d so far in 2008, natural gas injections are expected to be 210-220 higher in 2008 versus 2007.

Essentially the U.S. is exporting natural gas to Canada to help them increase storage levels. Our models indicate that in 2008 Canada should be exporting .92 BCF/d less natural gas than in 2007, due to production declines and increased demand in Canada. This indicates that we are sending .33 BCF/d more natural gas to Canada than is needed to offset their reduction in potential exports. The ‘artificial demand’ of .33 BCF/d equals 50 BCF so far in 2008.

We can now account for 395 BCF of the 492 ‘missing’ BCF of natural gas. A total of 238 BCF has been given to the global LNG market via reduced U.S. imports. A total of 50 BCF has been given to Canada for storage and 97 BCF has been given to Mexico to offset production losses from terrorism and to help them ‘get by’ until their LNG programs ramp up later this year and in early 2009. We do not believe these effects can occur again next year.

Disclosure: none

Comments

[Brian Pursley:]

Currently oversupplied? Methane has been and always will be infinite. It's the simplest hydrocarbon bond in the universe. Hydrogen is the most common chemical element in the universe and carbon is the fourth most common chemical element in the universe.

Isn't it ironic that the same lunatic fringe that thinks methane is quantifiable, finite, and depleting, practically has a heart attack every time a cow passes gas?

2008 Aug 14 04:57 AM

[fxtrader07:]

your own numbers totally contradict your conclusion and your eye-catching starting sentence: domestic supply @ 57bcf/day versus expected demand of 65bcf/day. And you call that 'massive oversupply'??
Give me a break! Of course, if you count global LNG you can make a cae of oversupply for each and every country in the world. The point is: why has domestic production replaced so much of LNG imports? Quite simple, costs! the crashing dollar has made LNG (with its additional transportation and storage costs) pretty expensive in comparison to domestic NGas.
Now, if you factor in that oil has gone up dramatically, even including the latest sharp drop, that coal has gotten up sharply, that additional fees for emission rights will soon further increase the costs of coal-based electricity then you look at a healthy and solid increase in longterm, sustainable NG demand. Nothing spectacular, no huge yoy jumps, but solid demand growth. LNG will not bring down prices anytime soon. us producers could easily suspend some production if need be and europe and asia demand a growing share of LNG for themeslves.
stocks of US producers like xto, chk are pretty much undervalued after the recent sell-off in the light of the bigger, longterm picture

2008 Aug 14 06:54 AM

[gashog:]

The lunatic fringe and environmental "save the earth by reverting back to prehistoric technology" group are against building more storage tanks in Delaware/NJ. As a result Americans will never enjoy the price breaks the supply demand curve which rules the free market economies often brings. Same with offshore drilling and harvesting the forests resources that the USA have which are periodically going up in flames from natural forest fires. The tyranny of vocal activist minority views ruling in our democracy is a travesty born of submission by the silent majority.

2008 Aug 14 07:10 AM

[MattB:]

Even if your analysis is correct (personally I think "massively less under-supplied" would be more accurate), what makes this secret (and I agree, it's not obvious to the lay-man) so dirty? Are you suggesting the natural gas price is artificially high, given your so-called massive oversupply? Why would a free market bear artificially high prices if there was a glut of nat gas in the pipelines? USA should be greatful that in this aspect of energy, it is almost independent, and not reliant on LNG to "fill the gap"; with the weak dollar correctly pointed out by fx.. and the rapid decline in domestic oil production, a short-term over-supply of gas ought to be cause for celebration (and continued investment) not crying the sky is falling.

2008 Aug 14 07:56 AM

[john s. gordon:]

and we haven't even started to harvest the methane hydrates under the permafrost. hurry up - the permafrost is melting.
> jack

2008 Aug 14 08:16 AM

[CT Programmer:]

As more and more NG pipelines are being built out all across the country, you will see more and more people switching from home heating oil to NG, especially in the NorthEast. Gas prices vary widely all across the country. As these pipelines even out those prices, I think you will see it drop. However, you're going to see higher demand for gas. So I think as oil rises, you're going to see more stability in gas prices at a reasonable level. And if gas prices drop too much, the gas companies (CHK, XTO, etc.) will cut back on production, thus bringing the price of gas back up. If we ever build out any real LNG export capacity, you're going to see gas prices go up by a lot.

2008 Aug 14 08:20 AM

[pockyclips ...:]

So where are the NG filling stations? Clearly, another case where the "free market" doesn't find the best solution to current problems.
Let's make oil from shale and tar sands instead, and stick our kids with the mess.

2008 Aug 14 08:30 AM

[happycajun:]

Hey, you have forgotten to factor in all the demand for NG as fertilizer feedstock - anyone who has spent anytime around agriculture knows that planting the same old crops in the same old dirt consumes all the nutrients and won't grow squat. In order to meet all the ethanol targets, a whole bunch fertilizer is needed (aside from the variety being generated in Washington DC in subsidizing this thermodynamically challenged energy policy) and NG is the feedstock for much fertilizer manufacture.

2008 Aug 14 08:49 AM

[Brahm:]

With regard to decreases in imported gas, perhaps, the explanation is not oversupply in the US. NG markets are very healthy abroad, and there is actually a shortage of supplies in the Persian Gulf (lower transportation costs due to contiguity). Many projects on the board or desired to be implemented in the near term in the Gulf region cannot find the gas feedstock required for them. Production is way behind demand and market needs. India, for example, has difficulties finding gas for near term needs (2 or 3 years ahead) of LNG from the Gulf. Not very successful. Power projects appear to be stalled in some of the emirates due to a lack of projected supplies.in the near and intermediate term. Drilling has not kept pace with burgeoning needs for power supply feeds. Prices are also very healthy for spot marker supplies in the Eastern region, and it perhaps does not make much sense to send ships laden with LNG over long distances to the US where prices are not that attrative.

So please be careful regarding the gift of your analystical powers!

2008 Aug 14 08:54 AM

[mouth:]

At first glance it does seem like the demand(China/India) is greater than the supply. But prices(the market) says it all. And coal/natural gas prices are dropping, which suggest greater supply than demand.

2008 Aug 14 10:16 AM

[Ozarker:]

We will be exporting LNG in the not so distant future, but increased production will keep prices from exploding.(no pun intended)

2008 Aug 14 10:38 AM

[Paul Killinger:]

I'm not sure your conclusions are much of a "secret" any longer. And, of course, one factor you don't discuss is transmission costs, which makes NG significantly cheaper or more expensive depending on where you live.

Apparently, Boone Pickens, who knows as much about this subject as anyone alive, isn't exactly "wowed" by our NG surplus. either. He's spending $2 billion to build wind farms, and take NG off the electric grid to make it available for use as a transportation fuel, as we speak.

But I agree with the gist of what you're saying. We keep finding more and more of this wonderful energy as we explore for it around the U.S. And that doesn't include the NG we may find when we open up the OCS.

Remarkable, isn't it? And, I might add, just in time!

2008 Aug 14 10:39 AM

[ABW:]

All of the above are interesting comments, but many are missing the point - one time issues are currently masking the oversupply situation.

Once these issues run their course (which is already starting as we begin to see the year-over-year (YoY) comps on LNG imports this month) storage levels will begin to move higher YoY. Note that LNG imports started to fall off late last summer with the following monthly imports for the US: July = 3.2Bcf/d, August = 2.8Bcf/d and Sept. = 1.4Bcf/d – and they move lower from there…

The difference in YoY storage levels is the main driver of short-term natural gas prices. Clearly there is a debate about what may happen in the long-term (US LNG exports or Pickens natural gas fuel US transportation fleets), but the analysis clearly shows that storage levels are going to be higher on a YoY basis over the next 9 to 12 months which will lead to lower natural gas prices. The really key thing here (and anyone who trades E&Ps should know this) is that Wall Street (WS) has factored very lofty natural gas expectations into company models and EPS estimates are currently very optimistic (I’m being nice here). On aggregate WS has Q308 through Q209 forecasts of: $11.50, $11.32, $10.42 and $9.50. The forward curve for the same periods is $10.41, $9.44, $9.27 and $8.99 (all from Bloomberg). With YoY storage set to go higher and natural gas prices set to move lower over the next few months EPS estimates are going to come down.

Let’s take CHK for example. Wall Street has $4.02 in EPS over the next four quarters. If you adjust quarterly estimates lower by the spread between current forecasts and the forward curve EPS goes down by over 11% to $3.57. With the stock at about $46.90 this estimate cut would take the forward P/E multiple to 13.1x from 11.7x. Now the 13.1x multiple may still look ok relative to the recent past, but the YTD valuations have been driven by growth expectations fed to investors by Wall Street. Backing out the last few months CHK has traded in a forward P/E range of 8.5x to 13.5x over the last three years. The stock is clearly more expensive than it appears at first glance. On top of this estimate cuts are never a good thing for stock prices. Considering the fact that the growth story will be questioned by investors over the next few months does anyone really think the stock should trade at the upper end of its historical range??? If you do I have some shares to sell you…

The really crazy thing is that the E&Ps are drilling more in the face of this clear (forward) oversupply situation... If you look at drilling permits you’ll notice that they totaled 6,600 in July up from 6,338 in June and up from 5,504 in July 07.

Note to fxtrader07 – the supply mentioned is lower 48 production and total demand is partially supplied by Canadian net imports which ran at about 15% of total US NG supply in 07 (take a look at the BP statistical review of world energy) – you can’t directly compare lower 48 production with total demand...

Note to Brahm – your analysis of the foreign gas situation is accurate – foreign gas markets are tight and prices are higher so LNG will not come the US unless it is under a firm long-term contract. If the US market were tighter and currency adjusted prices were higher the US would see more LNG imports, so the oversupply is a big reason for the lower LNG import levels…

2008 Aug 14 11:35 AM

[biomedlives:]

Brian - If you have carbon and hydrogen in forms other than methane, some chemical processing is necessary to convert them to methane. Thus the abundance of carbon and hydrogen in all forms doesn't help unless the cost of converting other forms is acceptable in light of the price of natural gas.

2008 Aug 14 12:00 PM

[Jrbarnes:]

The increase in supply of NG in the US has already caused US gas pices to fall to the $9-12 range, while international prices range in the $15-20 range. That is why the LNG is going elsewhere. International LNG will go to where it will get the best price - that is not the US. Thanks to the shale gas breakthroughs initiated in the Barnett Shale and since transferred ot other areas, the US has some of the lowest natural gas prices in the world already. Because of that, it is highly unlikely that any LNG will be coming to the US any time soon. The US is not the world's best place to be invested in an LNG terminal. Based on storage, US natural gas production has not created an oversupply, but is fully supplying demand - equilibrium, neither shortage nor surplus.

2008 Aug 14 12:16 PM

[Paul Killinger:]

Jack,

You're right, as well. Looonger term, gas hydrates will someday come on line. Since they contain 160X (!) the energy of NG per unit, people are doing the early R&D as we speak. And the U.S. has the most known reserves in the world off the coasts of AK and SC. While we won't live to see it, can you imagine South Carolina as a world energy leader?

2008 Aug 14 12:39 PM

[Nathan Weiss_:]

The 'Dirty Secret' is that energy insiders know that we are massively oversupplied, but the year over year storage numbers, the primary driver of natural gas prices (a -.78 corr over the past 2 years), did not begin to show the problem until now. Take a look at the storage forecasts we calculated on May 1 on the UNG sell idea in the sample report section of the Unit Economics site.

I believe natural gas prices wll hit $7.60 in coming weeks and average $6.00 in 2009.

2008 Aug 14 12:50 PM

[Nathan Weiss_:]

This is my correct user info (not User 243242)!

2008 Aug 14 12:51 PM

[Paul Killinger:]

Dunno about $6 NG, though. That would intone $72 oil.

We may be getting a bit ahead of ouselves here, guys.

2008 Aug 14 01:34 PM

[fran:]

NATHAN W--

if your $6 avg is correct, the utility companys will max out on NG. the transport guys will be accelerating conversion from diesel, and oil[?] cost/bbl. is it believeable?

it'll mess up everyone's models and Al Gore will be pushing it. believeable?

2008 Aug 14 01:51 PM

[experienced:]

It's unfortunate that those who talk about an imbalance in supply over demand fail to add the important qualifier, "at a given price." As natural gas prices fall, not all known reserves can be recovered profitably. Those who believe the U.S. has "massive" supplies fail to take into account the price factor. At $13/mmbtu, well, yes, the supplies would be massive. At $7, any glut would disappear shortly, especially as the winter heating season approaches. Given the energy relationship between natural gas and crude oil, Pickens plan makes sense to convert to the use of natural gas as an automotive fuel (initially it would be limited to fleet vehicles or vehicles that are driven only in a local area). But this limited additional use (think about mail and parcel delivery as an example) would make a huge difference in natural gas demand at current price levels and would probably be a much better solution than adding subsidized ethanol to gasoline.

Investors appear to be pricing stocks like CHK on the notion that there is too much supply (at current prices) in relation to demand. But CHK engages in very skillful hedging operations (most of the time, but not in the last quarter) that usuallly enhance earnings. In the last quarter, when gas prices rose well above their expectations, the hedging worked against CHK. Predicting future CHK earnings depends not only on the hedging operations but on the price of natural gasl.

2008 Aug 14 01:58 PM

[scfranklin94:]

Basically why Aubrey McClendon and Pickens are pushing so hard for NG to become a transportation fuel, is that the new shale plays will outstrip current demand for the rest of the next decade. CHK is about the most skillful hedger of all of the producers, but when it comes time to put on hedges for next summer, the price may be in $6 - $7 range; thereby locking in a huge disparity vs. crude.

2008 Aug 14 02:28 PM

[Nathan Weiss_:]

fran - the utilities HAVE maxed on on natural gas (this is part of my full 29 pg report on natural gas). Petroleu Liquids use for electricity is down 50% from 2005 and petroleum coke has falle. The other sources, Nuclear, Hydro, Renewables and coal basically have very little MARGINAL cost to run - you want to run them flat out as much as you can with current capacity. There really is no electricity generation that can shut off and be replaced by natural gas.

That said, by 2012 I expect natural gas demand for electricity generation to be 16.25% above todays levels, but this only adds 1.1 BCF/d in gas demand.

To put it another way, we generated 21.47% of our electricity from natural gas in 2007 and this used only 6.87 BCF a day. The current surplus of natural gas supply is nearly 4 BCF/d and growing!

2008 Aug 14 06:17 PM

[Beemer1200:]

"Dirty little secret?" So, what is so terrible about backing out LNG imports? This would seem to be a sustainable and economic outlet more domestic gas producers. If we had more domestic oil and backed down our OPEC imports would this be a dirty little secret for domestic oil producers? I don't get the point of the article.

2008 Aug 14 08:07 PM

[Chickenpookie:]

Get ready for oil in the $80 range, and I wouldn't be surprised to see even low $70's. That's when I'm looking forward to resuming my energy sector positions...

2008 Aug 16 01:57 PM

[Mechawreck:]

I work in the energy/power generation industry. I have no clue where nat gas prices will be next month. In 2 years they will be much higher..coal is in fact the "new nuclear" in the US (North America), in the sense that you cannot build them anymore. The US is left adding/replacing generating capacity in renewables and gas, thats it folks. Renewables (basically wind) comes slowly. The only thing that slows this train is a severe recession (dramatic declines in power demand). If Obama taxes carbon, coal plants will be shutting down (even more gas turbines). Good luck.

2008 Aug 16 06:39 PM

[Mmarrkk:]

Did you do a bit of research as to why LNG imports have fallen so low this year?? If you did you would understand a simple fact: even when gas prices in the US were $13/mmBtu, they were still lower than gas prices in the Far East (at $15 +). So why would a LNG shipper supply US markets with LNG for $13 when they could send it to Japan for $15?? That's the big secret (?). Until prices in the Far East drop or prices in the US rise, LNG imports will be severely reduced. Look at all of the new LNG import facilities that just opened this year. They aren't getting any LNG sent to them!!

2008 Aug 17 12:26 AM

[pacito:]

Chesapeake is going to plummet. Simple reason for that: They are on the verge of experiencing Peak production. Just have a look at the numbers of Texas Railroad Commission.
Statewide monthly gas well gas production for Chesapeake Operating:
Oct 07 32.9 Nov 07 31.5 Dec 07 31.1 Jan 08 29.9 Feb 08 27.4 Mar 08 27.8 Apr 08 25.7 May 08 25.1
So, production plummeted by 24% within 8 months. Within these 8 months NG prices surged from 6.17 (Q3 2007) to 11.34 (Q2 2008).
Also: According to Texas RRC, output from the Barnett Shale peaked in Dec 07 with 3.07 BCF and declined to 2.61 BCF (May 08) so far.
Shale NG is hot air, just declining too much.

2008 Aug 19 06:29 AM

[kebu77:]

The price differential between NG and oil and our balance of payments deficit (oil imports) means there is room for higher NG prices and more LNG imports.

We need to increase electricity production, electrify the railroads, expand frieght rail and get heavy trucks off the roads, thus cutting diesel consumption (helping to restrain jet fuel and home heating oil prices) and road maintenance costs.

In the short run, if energy security is a goal, we are currently under-using NG (at least until there is greatly expanded electric. prod. from renewables and nuclear).

2008 Aug 20 02:20 PM

[Mmarrkk:]

Why just look at Texas? Did you think to look at CHK's total company production? Across all states? They have been moving capital to other basins like the Marcellus, the Haynesville, etc. Look at their total production. It is increasing. But, if you would like, keep believing and even sell me your shares!!


On Aug 19 06:29 AM pacito wrote:

> Chesapeake is going to plummet. Simple reason for that: They are
> on the verge of experiencing Peak production. Just have a look at
> the numbers of Texas Railroad Commission.
> Statewide monthly gas well gas production for Chesapeake Operating:
>
> Oct 07 32.9 Nov 07 31.5 Dec 07 31.1 Jan 08 29.9 Feb 08 27.4 Mar 08
> 27.8 Apr 08 25.7 May 08 25.1
> So, production plummeted by 24% within 8 months. Within these 8 months
> NG prices surged from 6.17 (Q3 2007) to 11.34 (Q2 2008).
> Also: According to Texas RRC, output from the Barnett Shale peaked
> in Dec 07 with 3.07 BCF and declined to 2.61 BCF (May 08) so far.
>
> Shale NG is hot air, just declining too much.

2008 Aug 21 04:15 PM

[talkswitch:]

domestic supply @ 57bcf/day vs expected demand of 66bcf/day, This is a stunning domestic supply shortage.

2008 Aug 21 11:49 PM

[talkswitch:]

Domestic supply @ 57bcf/day vs expected demand of 66bcf/day, this is a stunning domestic supply shortage.

2008 Aug 21 11:50 PM

[chistletoe:]

Nice, careful research, Nathan.

I must presume that Brian is going behind a lot of cows and installing collection equipment. I sure hope he strikes it rich ....

2008 Aug 14 05:11 AM