The Marcellus Shale Time Bomb Is Ticking

Includes: CHK, ECA, UPL, XCO, XOM
by: David White

After an unseasonably warm winter in 2011-2012, US Nymex natural gas prices hit a near term low of $1.902/MMbtu in Q2 2012. Many E & P companies do not even break even at this cost. After some of the major natural gas producers cut back on production, the natural gas prices began easing their way back up. A heat wave that demanded energy for cooling helped. When the first signs of the el Nino winter forecast for North America this year showed themselves, Nymex natural gas prices moved up further. They have moved as high as $3.648/MMbtu recently. They are currently at $3.464/MMbtu. With a colder than normal winter approaching they may go up further in the near term. However, there is a time bomb ticking in the Marcellus shale.

According to Reuters, more than 1,000 natural gas wells in the Marcellus are waiting to be hooked up to pipelines that have not been finished yet. This is about 700 above the norm. More natural gas wells are being drilled all the time. Some companies have to drill to meet their lease held by production requirements. Other companies manage to be profitable even at very low natural gas prices.

The Marcellus is a prolific play. This is especially true of the best locations in the Marcellus. If all of the shut in wells come online in the next 12-18 months, this would boost US natural gas production by 2.4 Bcf/d, and this doesn't even include any new wells of which there are certain to be many. The EIA expects production of natural gas in the US to rise to 68.72 Bcf/d by the end of 2012; and this is without virtually all of the 1000 shut in wells cited above. It expects output to rise another 0.8 Bcf/d in 2013 to 69.52 Bcf/d. However, it has not added in the output from the shut in wells in the Marcellus.

Plus, many other wells owned by Chesapeake Energy (NYSE:CHK) and other big producers, which were shut down in order to prop up natural gas prices, could be brought back online at any time. Add the many not as yet connected wells in other fields, and you may have quite an appreciable number. The 1,000 shut in wells waiting for pipeline completion in the Marcellus alone amount to an extra 2.4 Bcf/d. As a ballpark guesstimate, such wells in all other US natural gas fields might come to 5.0 Bcf/d. If you add these to the expected production of 69.52 Bcf/d in 2013, you get a much bigger figure of 76.92 Bcf/d.

This is without even adding in all of the wells temporarily shut in by the bigger producers to help natural gas prices rise. The current EIA forecast for natural gas use in the US in 2013 is 70.91 Bcf/d. My figures above mean there will be a considerable oversupply if shut in wells are connected to new pipelines.

Are there enough pipelines going in to provide such an increase? The answer in the Marcellus is a definitive yes. In the next 12-18 months over 20 pipeline projects associated with the Marcellus are set to go into service. These pipeline projects have a total capacity of about 8 Bcf/d. If you consider that the pipeline companies would not be building the pipelines at all without firm contracts for their use when finished, this translates into a lot of new natural gas production.

As a ballpark figure, one would estimate that the pipeline companies have firm use contracts for at least 60% of the pipelines' capacities. This amounts to nearly 5 Bcf/d of new output by the end of 2013 from the Marcellus alone. This is far above the 2.4 Bcf/d mentioned above. The table for the Marcellus pipeline projects is below (Reuters).

Companies will not want to pay pipeline costs, if they do not ship their natural gas. This almost certainly means that a lot of new gas will be shipped. Critics might now say there are different types of pipeline contracts. Yes there are, but virtually all of them involve considerable fees, even if you don't ship your gas. Plus the pipeline companies are not foolish. They will have gotten firm guarantees for the pipeline openings.

US natural gas prices appear to be in for another very tough year next year. It is my opinion that the EIA has likely seriously underestimated US natural gas output for 2013. The extra production that I see coming is likely to hurt the largest natural gas producers, but it may be some of the smallest that are least able to weather the storm, especially if there is a recession in the US in 2013. A table of the top 20 natural gas producers in the US is below.

The biggest US natural gas producers such as Exxon Mobil (NYSE:XOM) and Chesapeake Energy will be hurt, but they will weather the storm. They are financially more sound, and they have significant oil interests as well. Other companies, which currently have non-existent trailing twelve month P/Es, may be in more trouble. These include companies such as Penn Virginia Corp. (PVA), which already is forecast to lose money in both 2012 and 2013, Ultra Petroleum Corp. (NASDAQ:UPL), which is almost all natural gas, Encana Corp. (NYSE:ECA) which is heavily natural gas, and EXCO Resources Inc. (NYSE:XCO), which is almost all natural gas.

All of these last four should be impacted severely. Some of them such as XCO are in very questionable financial shape already. If I am correct about the natural gas situation in the US, these last four companies may all be in worse shape by the end of 2013, especially if there is a recession in the US in 2013. This last is looking increasingly likely as the fiscal cliff nears without any substantive action from the US Congress.

EU economic data have weakened noticeably lately, and US technology earnings are seeing pressure, as the EU is a significant market for most good sized technology companies. In general big US multi-national companies have disappointed in Q3 2012 earnings. If I owned any one of the latter four companies listed above, I would sell it now. I admit that I find some appeal to the last three, but I would prefer to wait to buy any of them until after they weather the coming storm. If the US Congress passes a natural gas for transportation bill, I might want to re-evaluate my position. However, for now I am more inclined to go short these last four stocks than to go long them. If you are an aggressive trader, you might want to consider going short any of the four.

Alternatively, one strategy you may wish to consider is to wait to more fully evaluate the situation with the US fiscal cliff and to see more of the actuality of the el Nino winter. Natural gas prices have not really turned dramatically down yet. In fact they may go up in the short term. However, it seems likely they will turn downward for the reasons I have described. You may wish to use such a downturn as a signal to short one or more of the last four stocks above. All of them have weak charts; and there are good reasons that they do. For your information, the total debt to total capital ratio (MRQ) for each of the four is: PVA -- 48.52%, UPL -- 81.25%, ECA -- 58.20%, and XCO -- 70.51%. Each has a significantly higher ratio than the industry average of 30.90%. Each should suffer more severely in a recession compounded by low natural gas prices. All of them have weak charts.

Note: Some of the above fundamental fiscal data is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in XCO, UPL, ECA over 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.