Natural Gas: The 'Goldilocks' Storage Picture Is Masking Deep Containment In The Marcellus

by: Richard Zeits

Natural gas supply and demand appear well-balanced, lending support to the Henry Hub stability thesis at ~$4/MMBtu.

New takeaway capacity schedule in the Northeast Region defines the trajectory of natural gas supply, and is the key driver to monitor.

Chesapeake sees no relief to the Marcellus North constrained situation in 2015, with gradual relief in 2016-2017.

The short-lived natural gas price spike earlier this year - to the $4.50-$5.00/MMBtu level, using the winter 2014/2015 futures - appears to have been a perfect one-time stimulus to producers to bring their output volumes to a higher but stable level.

The storage deficit versus the 5-year average went from ~900 Bcf at the beginning of the injection season to ~373 Bcf currently. Goes without saying, neither figure should be interpreted as a measure or indication of imbalance between supply and demand, but rather, as a reflection of abnormal weather pattern: the initial deficit was the consequence of the severe winter, and the strong contraction of that deficit is in large part explained by the abnormally cool summer.

The most recent storage injection data provides evidence that supply and demand are in fact in almost a "goldilocks" balance. While storage injections are running at a rate that exceeds the five-year weather-adjusted average, this excess supply is hardly a threat to the Henry Hub price. First, this surplus is moderate, while storage capacity remains ample, particularly in the producing region. Second, current injection rate excess over the five-year average is somewhat overstated by weekly headline figures, due to the fact that available storage capacity is more broadly distributed at the moment, relative to what would be a seasonal norm. At the end of a typical injection season, when capacity is near full, some injection points begin to experience congestion, leading to a slowdown in the injection rate. That point has not been reached during this injection season yet.

As a result, the current aggregate production level appears almost optimal, and is unlikely to create a need for a major price signal to producers, similar to the one we saw earlier this year, to adjust production volumes for quite some time. The new "control point" is now likely the end of the injection season 2015, when storage capacity may again emerge as a limitation on production volumes and a potential factor for the Henry Hub price.

The flat futures curve, which averages approximately $3.90 MMBtu for the next 12 months, appears very logical structurally and fairly priced. The curve may also be interpreted as suggesting that the ~$4/MMBtu Henry Hub price is the price that supports supply/demand balance in the market, providing enough economic stimulus to producers to maintain production levels, but not sufficient to substantially accelerate production.

(Source: Zeits Energy Analytics)

The only element that rudely interferes with this almost idyllic picture is the deep containment price environment that is being experienced in the nation's most important producing region, the Marcellus and Utica. The Northeast Region natural gas production is akin to a very powerful, strongly compressed spring. If takeaway constraints could be resolved, the region has the capacity to add several Bcf a day of production to the current supply in a very short period of time, easily tipping the balance that currently exists.

Standing in the way are local Marcellus prices that in certain pricing points continue to be at shut-in economics level. For example, recent Tennessee Pipeline Zone 4 prices have fluctuated in the $1.75-$2.25/MMBtu range.

It may take some time before the severe constraints can be relieved. The Marcellus North region is particularly constrained. Chesapeake Energy (NYSE:CHK), presenting at an industry conference yesterday, made the following comment on the pricing outlook for the Marcellus North:

The pipe access in the Northeast is a challenge. There is a lot of pipes under construction and more in the planning stages. We have an active discussion with all of those pipes, trying to figure out where the best access to markets are going to be, what the best cost structure is going to be. You can map it out and see that there is not a whole lot to expect in terms of huge improvement in 2015. There is more to see in 2016 and then even more in 2017. So, when I think about the basis issue in the Northeast, I do not expect 2015 from a pricing standpoint to be really any better than 2014 and we are planning our business accordingly, that's why we like to keep production flat.

Of note, Chesapeake mentioned that it only needs to run 3-4 operated rigs to maintain its gas production in the Marcellus North flat. This is substantially lower than the 5 rigs/$300 million net maintenance capital estimate that Chesapeake provided earlier year. Chesapeake's net production in the Marcellus North during Q2 2014 was ~0.9 Bcf/d. The company's gross operated production is much higher, at ~2.2 Bcf/d. 3-4 rigs maintaining 2.2 Bcf/d of production flat - this is a truly impressive metric.

The remarkably low rig requirement to keep production flat is a testament to the productive capacity of the Marcellus' sweet spots and shallow production declines from the existing wells after operators put them on restricted choke programs. With Utica demonstrating equally strong productive potential in the dry gas area, production deliverability from the region is very powerful.

For the time being, operators in the Marcellus and Utica have to restrain their pace of drilling. Chesapeake commented:

In the Marcellus North, we're not spending a lot of money today. Great rates of return in the Marcellus North, absolutely phenomenal rates of return, but only for the gas that you are getting into the takeaway pipes. So gas that you sell in the field in the Marcellus North -- you've seen it written about quite a bit - it's not getting a good price these days. We are minimizing that, we are keeping our production flat in the Marcellus North.

As all the new pipelines in the Marcellus area are going to be full, the takeaway in-service schedule in the Northeast, not the drilling economics, is the critical factor that will determine the dynamics of natural gas prices in the next 24 months.

Stock Implications

Examples of stocks strongly impacted by the regional differentials in the Marcellus region are:

  • Cabot Oil & Gas (NYSE:COG)
  • Range Resources (NYSE:RRC)
  • Antero Resources (NYSE:AR)
  • Rice Energy (NYSE:RICE)
  • Noble Energy (NYSE:NBL)
  • Consol Energy (NYSE:CNX)

Integrated producers with significant exposure to the midstream should be able to partially mitigate the impact via direct participation in the midstream profits. Examples of such stocks are:

  • EQT Corporation (NYSE:EQT)
  • National Fuel Gas (NYSE:NFG)


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