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What is Driving Natural Gas Pricing and Continued Drilling?

|Includes:The United States Natural Gas ETF, LP (UNG)
So here we are, coming to the end of the cooling season, one for the record books as the population weighted CDD's (cooling degree days) look to post an all-time record this summer. This season has been rather extraordinary when looking at the supply/demand balance. We had such a bearish supply side story last year with all the domestic production growth in shale and quite a cool summer that lead to a new end-of-season storage record of over 3.8 TCF. So many had called for large production declines with prices falling and high decline rates in shale. What these people did not understand, and continue to miss are the dynamics of leasing acreage.

When Haynesville just started to gain attention for how prolific it was, prices had climbed to as high as $13.00+ on nearby NYMEX futures. The economy was singing along, oil was trading well over $100 and "peak oil" was gaining wide-spread attention. E&P companies were scrambling to get acreage, not wanting to be left out of the gold rush, paying as high as $30,000 an acre in some extreme instances. There were widespread leases averaging at $15,000 to $20,000 per acre, and largely these all had three-year timeframes to drill with a 25% royalty. Now understand this, when a company leases acreage, they pay the lease "bonus" up front, a sunk cost. The only way they recover this cost is to produce commodity from this acreage or sell it to another company, which doesn't change the terms on time of lease, whoever holds the lease has three-years to drill and have production. To hold acreage beyond the three-year term, it must have at least one well drilled and producing for each section, and a section in Haynesville is 640 acres. Once you meet this requirement, you have HBPed it (hold by production).

The sheer amount of capital that was sunk into leasing is what has dominated the drilling environment, and these producers will continue to drill to HBP this acreage even if they are well below break-even. Would you rather recover $14 million back on a capital outlay of say $18 million (lease costs and drilling combined), a net loss of say $4 million, or walk away from a lease you paid $15,000 acre*640 acres for your initial sunk cost of $9.6 million (or greater for those that paid higher)? Add to this that the profit will be recovered later in the game when you drill other areas within your initial 640 section with no additional lease costs, bringing your breakeven gas price much lower.
Timing when this new gold rush commenced, the average three-year leases will expire from this initial boom in Haynesville, starting largely in Q2, Q3 and Q4 of next year (2011). There is still quite a bit of acreage that needs to be HBPed in this timeframe, and is the reason why rigs in this play are still running high, despite the widespread idea of falling prices this winter on an expected warmer than normal temperature forecast. The primary tool that many producers are using to mitigate larger price risks in this environment is forward price hedging. Scanning through the public filings of some larger participants, turn up robust forward hedging programs with large volumes sold at higher strip prices, thus partially shielding them from this falling price environment and allowing them to continue to HBP their requirements.
Another interesting thing I keep hearing is how many companies are now starting to focus on liquid rich shale and oil shale. What many people are missing here is that even in these plays, there are still large gas volumes in the overall production stream. I remind you of the very large quantities of natural gas in the Macondo “oil” well disaster of the Gulf this summer. Add to this the leasing costs environment of these other shales being quite a bit lower than what was paid for Haynesville acreage, and lower overall drilling costs making breakeven pricing lower and you can see that again, companies that understand this price environment, have locked into higher price forward sales to mitigate while continuing to HBP these properties.
One good shale play to study is the Barnett, a play that is largely mature for many reasons; timing and HBP are the primary drivers here. This play has seen a steady drop off in output due to lower prices; this is because of two reasons. First, I believe that the vast majority of Barnett has been HBPed, so there is no forced drilling/production taking place. Secondly, many of the rigs that were operating here have been moved to other plays for HBP purposes. In the end, when we indeed find ourselves in a higher price environment once again, rigs can be brought back to drill new wells/complete new runs and boost output to meet a higher demand and price. And this will also happen in the newer plays as well such as Haynesville in the future.
In summary, the behavior we are seeing from producers in this low price environment is a forced one. It is merely a rush to hold onto their vast sunk cost investments. I believe once we are past the mid-point of 2011, we will see a structural shift in drilling behavior to reign in and allow producers to return to a market where drilling is largely determined by forward pricing opportunity. Over the next several years, we will likely see quite a bit of demand growth in the gas sector as well. There are going to be coal generation retirements on top of expected new power generation growth that will likely lead to greater gas-fired generation growth to meet these needs, so there is a light at the end of the tunnel. However, to those that keep calling for a rapid and eminent drop in supply, I hope this article will help illustrate what is driving this drilling pace. We will eventually work through this, but hopes for a full fledged bull market are still likely a year away at this point, and that is also dependent on the global economic environment. Once we do get into the next cycle higher, it should not be forgotten, how fast shale production can be ramped up to meet increasing prices and demand, it has been called “gas manufacturing” and is here for awhile yet to come, likely keeping old record pricing of years past still a long way into the future.

Disclosure: Bearish various forward structures in futures/options
Stocks: UNG