The Downfall Of 'Peak Gas' Theory

Jun. 26, 2017 10:50 AM ETUNG, UGAZF, DGAZ, BOIL, GAZ-OLD, KOLD, UNL, DCNG67 Comments
Richard Zeits profile picture
Richard Zeits
10.37K Followers

Summary

  • The market is finally recognizing the success of shale gas: the futures are pricing Henry Hub below $3/MMBtu for the next five years.
  • One of the industry's most notable achievements is a flatter cost of supply curve.
  • The flatter curve is likely to be sustained for an extended period of time, despite growing volumes.
  • The industry's success is not necessarily investors' success - a flat supply curve is one of the greatest enemies of the stock price performance.

“Shale Gas Revolution” is still a teenager. However, the volume of operational and financial evidence demonstrating that natural gas shales “work” is overwhelming at this point. This evidence leaves no doubt, in my view, that North America is well supplied with low-cost natural gas (UNG) for at least a decade, and possibly much longer. Given that natural gas shortages were a clear and present danger as recently as 2008, this is a true paradigm shift for the continent’s energy security (and, arguably, the world’s energy security).

During the new technology’s early years, shale skepticism was understandable. However, at this point, “peak gas” and “gas shales do not work” claims have largely moved into the category of conspiracy theories.

As they say, the proof of the pudding is in the eating. Two macro metrics – volumetric growth and market price - speak loudly in support of shale gas having a low cost of supply. Geologic assessments of resources in the ground indicate that this low cost of supply is likely to be sustained over a long period of time.

As consumption grows, over time, natural gas prices may increase materially above the ~$2.85-$2.90/MMBtu range predicted by the current futures curve. However, even then natural gas in North America is likely to remain an affordable and market share winning energy source.

Rapid Volumetric Growth

Since the beginning of the shale revolution, natural gas has won significant market share in the U.S. energy balance, growing at a rate far exceeding total energy consumption growth. During the decade ending 2015, U.S. natural gas production increased at a rate of ~4% a year, a remarkably rapid growth pace for a major commodity.

U.S. ProductionShale gas skeptics often flag the fact that U.S. natural gas production has been stagnant since 2015, attributing the slowdown in growth to the shale gas industry not living up to optimistic expectations. This slowdown is sometimes presented as a harbinger of even greater problems ahead.

The concern is without merit, however. The two in a row abnormally warm winter seasons - 2015/2016 and 2016/2017 - severely reduced demand and were the obvious cause of this growth slowdown. The industry was forced to reduce production volumes to meet storage constraints.

Of note, North American storage was essentially full at the end of every injection season in the last six years (with the only exception of November 2014 that followed an abnormally cold winter).

Low Prices Have Been Sufficient To Support Rapid Growth

This remarkable volumetric growth has been accomplished despite a continuous decline in natural gas prices. In fact, since the beginning of 2012, Henry Hub spot price has averaged just $3.18 per MMBtu. This compares to the average price of $7.10 per MMBtu during the five years from 2003 to 2008. The contrast is even stronger if inflation is factored in.

Historical Price

It is important to note that the relatively low price in the last several years was sufficient not only to stimulate strong growth in volumes but also trigger a massive infrastructure buildout. A case can be made that an even lower price will be sufficient going forward to meet demand, as local differentials will contract once adequate takeaway and processing capacity comes in service.

In fact, the market appears to agree. The futures curve indicates that natural gas is a “sub-$3/MMBtu commodity” for the next five years.


FuturesOperators Report Massive Commercial Resources

Shale skeptics often claim that the recent natural gas prosperity is a temporary phenomenon, as shale producers will soon exhaust the most prolific sweet spots and again struggle to meet demand. The concern is indeed valid, as the cost of supply in shales varies widely depending on rock quality. However, it is important to define the term “soon” in this context.

In fact, the trend over the last several years has been towards rapid expansion of the industry’s sweet spot footprint, as large new areas were delineated and extraction techniques perfected. It is also important to note that U.S. natural gas plays that pioneered the shale gas revolution are not the only area of growth on the continent. North America is endowed with a vast set of sedimentary basins that stretch all the way from Canada to Mexico. Canadian shale and tight gas plays offer massive potential to grow supply while Mexico’s shale resources have been largely untapped.

While the cost of North American natural gas supply may increase at the margin over time significantly, “soon” in this context likely means a decade or possibly even longer. In the meantime, leading operators continue to increase their estimates of commercial resources in the ground, with more data available every year to substantiate the estimates.

Antero

(Source: Antero Resources)

Tremendous Economic Value Has Been Created - Mostly For Consumers

“Shales don’t work” advocates often allege that natural gas industry is not economically viable, as producers have spent more money acquiring and developing acreage than they generated in cash flow. Some go as far as compare shale gas industry to a Ponzi scheme, where production can grow only with the support from external capital injections.

The argument has no economic merit, however. First, it ignores the concept of sunk cost. Even if capital invested to date fails to produce expected returns, this fact would have little relevance for the cost of supply going forward. Second, the argument fails to recognize the value created by the industry in the form of the vast captured resources, infrastructure, supply chain capacity, and extraction technology. Significant upfront investments have been made in these critical aspects of natural gas production in the last decade. Finally, the argument implicitly suggests that the technological breakthrough should have accreted to natural gas producers. In a competitive marketplace, this presumption is incorrect. Producers can only benefit from their differential advantages. Given that the cost of supply has in fact flattened, consumers are the greatest winners, whereas many stock investors find themselves disappointed - thanks to the industry’s remarkable success.

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This article was written by

Richard Zeits profile picture
10.37K Followers
Richard Zeits is an Oil & Gas industry analyst and consultant. His background includes fourteen years as Energy industry-focused investment banker, portfolio manager and senior investment analyst with bulge bracket firms in New York. Zeits Energy Analytics use elaborate proprietary analytics and data bases to provide in-depth industry research, market intelligence, and forecasting.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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