The Impact Of A Looming Natural Gas Supply Problem

Few people have noticed that there is a looming North America natural gas supply crisis that could come within 6 months. A shortage in NG (natural gas) will occur due to a production collapse in Canada, and inability of US shale gas producers to sustain drillings.

Capital Destruction in Natural Gas

US natural gas was over-supplied due to a shale gas production boom that will turn bust. The hydraulic fracturing (fracking) in shale gas production injects a toxic liquid with undisclosed chemical ingredients. But shale well drilling also requires another liquid very harmful to a corporation's health: cash liquidity from debts.

Cash liquidity is the lifeblood of all businesses. Shale gas wells are expensive to drill. NG producers took huge loans from banks to drill shale wells, hoping to recoup the costs from product revenues to pay back the loans and to use the money to drill more wells.

All conventional and shale gas wells are in continuous production declines. Another SA article discussed such declines. Read how Halliburton (HAL) explained (on page 22) "Why do we need to keep drilling". The NG industry must keep drilling to fight against the continuous declines of existing gas wells.

However, as current NG prices are deeply unprofitable, producers cannot recover their costs from gas sales. This results in capital destruction at an astonishing rate. With heavy debts, it's difficult for NG producers to borrow more. So they may not continue to burn cash and drill new wells. Soon the production decline will catch up, leading to a collapse of NG supply. Wolf Richter suggested that scenery. He stated:

The plight of natural gas driller Chesapeake Energy could almost make you feel sorry for the board of directors and CEO Aubrey McClendon. He lost his chairmanship after his conflicted entanglements and an in-house hedge fund seeped to the surface. The company announced it might run out of cash to fund its drilling operations next year. Fitch, in downgrading Chesapeake's Issuer Default Rating and senior unsecured ratings to BB-, estimated that the shortfall this year alone would reach $10 billion-in the first quarter, the company bled $3 billion in cash-and that it would be forced to dump up to $20 billion in assets to get through this...(read more)

South Western Energy (SWN) disclosed (page 6) that it costs $10M to $12M to complete a well. Roughly 900 new wells are added to US production per month. So the NG industry spends about $10B per month just to drill wells. US gas production is about 2000 BCF per month. It is worth about $4.8B at $2.40/mmBtu. So the industry collectively loses $5B of cash per month, or $15B a quarter, not even counting the general and administrative expenses.

Canada Has Its Own Natural Gas Crisis

Another NG crisis looms quietly in our northern neighbor.

Canada's NG production peaked in 2001 at 17.4 BCF/day. In 2010 it dropped to 14.4 BCF/day. The Global and Mail reported recently that Canada's NG production took a steep dive, dropping by 0.190 BCF/day per month. That's a 1.32% monthly drop, or a 14.75% annual drop.

Like in the US, Canadian NG producers cannot cover their costs due to low gas prices. They have to put off drillings to preserve cash.

Will producers promptly rush back to drill more gas wells once the NG prices recover? I think that is unlikely:

1. The NG industry has learned its lesson of over-production
2. They are short in terms of cash liquidity due to capital destruction thanks to low NG prices. Their priority now is preservation of cash liquidity, not aggressive capital spending.
3. Banks trusted the rosy promises of shale gas to lend money to the shale gas players. But the results are disappointing. They will not be fooled again to lend easy money.

Due to the double whammy of NG production collapse in both the US and Canada, I believe there will be an NG shortage in a few months. The NG prices will rise a lot. But the coal sector will benefit more.

The Supply and Demand on Natural Gas

I have tracked the supply and demand data closely on coal and on natural gas. EIA only published monthly data up to March 2012 so far. But I can reconstruct the April and May data based on Weekly Natural Gas Updates, Weekly Coal Productions, and a FERC chart on electricity demands. Note the demands recovered in May of 2012:

For details on my data processing, read my instablog. I will present the results here without lengthy elaborations.

NG supply has been dropping since January of 2012, but you may need a magnifier to see it:

My chart shows the decline better:

The weekly NG supply dropped 4.4% from 499 BCF/week at start of 2012 to 477 BCF/week today. The loss was 1 BCF/week per week. The drop rate was 10% annualized.

The above table contains monthly NG supply and demand numbers, scaled to 30-day months for uniformity. Read detailed discussions.

The natural gas storage started injection on March 9, 2012. The comparison shows that the injection was much slower than normal:

In light of the 62 BCF injection last week, United States Natural Gas (UNG) dropped 6.12% yesterday. People once again feared that the storage would reach full capacity (about 4400 BCF) by the fall.

I think the fear is unfounded. The supply drops by 1 BCF/week per week. There are 25 weeks left till the fall. Injection for 12 weeks so far was 508 BCF, or 42 BCF/week. If we start with 42 BCF/week injection and drop by 1 BCF per week for 25 weeks, the average weekly injection will be 30 BCF and the total is 750 BCF. So it will bring the storage to 2877 + 750 = 3627 BCF, below the normal storage peak of 3800 BCF.

In the latest weekly update, NG demand in power dropped 10%. It was only 3.3% higher than a year ago. I think this implies that the dispatch switching from coal to NG is now over. The coal demands displaced due to competition from NG have returned to coal.

The Supply and Demand on Coal

In the coal sector, producers have curtailed productions massively:

In the last two weeks, the production interestingly ticked up a bit. I examined the numbers and found that the increase concentrated in four western states: Wyoming (+0.5M); New Mexico (+0.23M); Montana (+0.14M) and Colorado (+0.1M). I think the increase might be due to increased exports to Asian countries.

I believe the supply and demand in coal is turning around. Here are the monthly numbers, scaled to uniform 30-day months:

Note the last column with coal stockpile numbers. The power sector stockpile stood at 196M tons in March. By May, it dropped slightly to 189M tons, within normal range (I extended the line to May):

Invest In Coal, Not Natural Gas

The NG and coal sector is rebalancing. The supply and demand fundamentals are turning bullish for both energy commodities.

Not only the NG prices are going a lot higher, we must also be prepared for the scenery that even as the NG prices recover, producers may not immediately rush back to drill wells. They may not have the cash for aggressive drillings. The banks may not be willing to keep lending them more money. If my hypothesis was right, we might see a natural gas shortage by the end of 2012.

I continue to caution people not to jump into natural gas plays just because NG prices are going up. Many NG companies have racked up huge debts chasing the shale gas boom. They are now left with little hope of recouping the costs. Many plan to sell assets in the next two years to survive. But who will be the buyer if everyone is selling assets? Not to mention the ongoing controversy on shale gas. So I would stay away from these names until the dust settles:

• Chesapeake Energy Corp. (CHK)
• Constellation Energy (CEP)
• Cabot Oil & Gas Corp. (COG)
• ConocoPhillips (COP)
• Anadarko Petroleum Corp. (APC)
• EOG Resources Inc (EOG)
• Devon Energy Corp. (DVN)
• Baker Hughes Inc. (BHI)
• Southwestern Energy Co. [SWN]
• Sand Ridge Energy (SD)
• Pioneer Natural Resources (PXD)
• Magnum Hunter Resources (MHR)
• Kinder Morgan Energy Partners (KMP)
• Enerplus Resource Fund (ERF)
• Carrizo Oil & Gas (CRZO)
• Callon Petroleum (CPE)
• Enterprise Products Partners LP (EPD)
• Goodrich Petroleum (GDP)
• GMX Resources (GMXR)
• IDT Corp (IDT)
• Lucas Energy (LEI)
• Rex Energy (REXX)
• Approach Resources (AREX)
• Natural Gas Services Group (NGS)
• Breitburn Energy Partners (BBEP)
• National Fuel Gas (NFG)
• Range Energy Resources (RRC)
• Petroquest Energy (PQ)
• Unit Corp. (UNT)

The coal-mining sector is still a better investment opportunity to leverage on a rebound in coal and NG. I continue to recommend these great values in coal:

• James River Coal Company (JRCC)
• Patriot Coal (PCX)
• Arch Coal Inc. (ACI)
• Cloud Peak Energy (CLD)
• Alpha Natural Resources (ANR)
• Consol Energy (CNX)
• Black Hills Corp. (BKH)
• Walter Energy (WLT)
• Westmoreland Coal (WLB)
• Peabody Energy (BTU)
• Nacco Industries (NC)
• Alliance Resource Partners LP (ARLP)
• Market Vectors Coal ETF (KOL)

The Bankruptcy Rumors on Coal Companies

Some speculated that if PCX could not get a new credit facility from the banks, it might go bankrupt soon. Some emailed to ask me to stay away from PCX.

My take is that should the coal sector remain depressed for long, like 2 or 3 years, some weak coal players may not survive. But the coal sector is inherently cyclical with a quick turnaround. The coal fundamentals are gearing up for a big rally soon. The turn around is within one or two months, not years, based on my tracking of the coal stockpiles.

Banks that had worked with coal companies understand the cyclical nature of the coal sector. PCX already entered into a commitment letter for a new loan. Banks have their best long-term interests to work with coal companies patiently for the sector to rebound.

If you are not convinced, take a look at some dry bulk shipping companies that are still hanging around long after the collapse of the shipping sector in 2008:

• Excel Maritime (EXM)
• Eagle Bulk Shipping (EGLE)
• DryShips Inc. (DRYS)

These shippers are in terrible financial shape. They have high debt and depressed asset values. The shipping sector is suffering from a multi-year glut of ships and low shipping rates. In the coal sector, producers can curtail production to quickly balance supply and demand. But in shipping, over-supply of ships does not go away fast. Even of some shippers file bankruptcy, the ships will be sold and will remain in service, so the glut of ships remains. It takes many years to dismantle old ships and reduce the global fleet size.

Yet thus far, banks have worked patiently with shippers to wait for a sector rebound. They tried to not push for bankruptcies. Banks know helping shippers to survive is in their best long-term interests.

If banks can work with companies in a sector with such a long low cycle, it's much easier for them to work with coal companies. They should know from history that the turnaround in coal is much faster. Although theoretically PCX can go bankrupt, the practical chance it happens is almost zero. The potential reward of a coal sector rebound is so high that it is worth taking some risks.

I am buying more PCX and other coal stocks.

Disclosure: I am long JRCC, PCX, ACI, ANR, BTU.