Under the combined impact of unusually warm weather and ballooning supply, natural gas prices have taken a beating this winter in North America. Recent announcements by Chesapeake Energy and ConocoPhillips that they will cut gas drilling operations is an important first step towards shoring up the beleaguered price of natural gas. We even saw a short term bump in price immediately following.
But will this be enough to ease the pain? Our research suggests not.
The consensus response to $2.50 gas is a near unanimous switch in focus and capital to drilling in more liquids-rich North American unconventional resource plays.
There are at least two key questions:
- Will the shift to liquids-rich drilling affect oil market conditions?
- Will this solve the gas problem?
Three fundamental forces suggest that near-term cutbacks will not solve the problem: (1) gas volumes from liquids-focused plays, (2) the OPEC dilemma and (3) the cost of supply curve.
1. There are still significant volumes of natural gas that are and will be produced from these plays:
Consider, for example, unconventional resource growth projects in the United States and Canada. Limiting the results to projects in which liquids will constitute 20% or more of cumulative future gross BOE supply, what percentage of future production is gas?
Gas production from 2012 through 2030 represents 38% of the total future production from these assets. So long as oil prices remain high, do not expect any curtailing of drilling by companies with acreage positions in these liquid-rich plays to help their competitors in the more gas focused plays. Our analysis shows that aggressive drilling programs focused on these liquids-rich plays will double gas produced from these projects over the period from 2012 through 2015 and growth will continue to 2020 and beyond.
An important point here was made by Steve Farris, Apache's CEO, in a Q&A session concerning Apache's US$2.85 billion acquisition of Cordillera Energy Partners III, LLC. When asked how gas price expectations affect the deal he responded:
What's happening on the gas side today is what happened back in the early 1970's in the Rocky Mountains. You got rid of your gas so you could produce the liquids. ... the real value of this play is the liquids component of it; not the gas side. We could change the gas price in this thing a buck and it's not going to change the economics much.
Another Apache executive on the panel added:
... we are valuing the revenue. If it's 80% liquids it tells us we're not paying much at all for the gas. it's almost like we are buying the liquids and the gas is thrown in for free.
2. The OPEC dilemma:
The results in figure 2 are based on projects for 33 of the major players in these resource plays. These companies are key drivers of supply but there are a very large number of smaller companies that are active here as well. Everyone, including government, analysts, and management in oil and gas companies, consistently underestimate how competitive the onshore North American business really is and what that means.
This is one part of the classic OPEC dilemma. To the extent to which production curtailments and reduced gas-rich drilling causes North American gas prices to rise, other producers will respond by increasing drilling. Therefore, is there any way for natural gas prices to rebound to the levels required by many recent JV alliances and acquisitions on a sustained basis without significant steps for market building in the United States? There is one important difference between the North American situation and OPEC's efforts to keep global oil prices high. While the NOCs can control access to additional growth assets in their host countries, in North America, there is no entity capable of restraining new competitive supply sources as a means of defending a price level.
Will ConocoPhillips or Chesapeake Energy cease production from both its natural gas and liquids-focused plays to provide a boost for ExxonMobil, Chevron or Total; and vice versa? Not with oil at $100 per barrel; not after 30 diverse companies have invested US$145 billion in major deals over the past 5 years to gain entry; and not when rapid production growth is the consensus strategic goal of nearly every company from China to Oklahoma City.
3. Flat and Volatile Cost of Supply Curve:
The following figure is an excerpt from a management presentation at ConocoPhillips' March 2010 Analyst Meeting. In the past few years this sort of graphic appears in one form or another in almost all companies' investor presentations. The graphic shows a ranking of different unconventional plays based on the minimum Henry Hub price required to yield an acceptable return.
In effect, each of these companies has been arguing the same thing: that their acreage position makes them the Saudi Arabia of North American gas. The intent being to reassure analysts and investors that (1) there is an acceptable floor under natural gas prices and (2) the company's acreage is concentrated in low cost areas on the left hand side of the chart that will still be profitable even at that floor price.
For the past three years in client presentations and in On Point, we have made it clear that there are two different, more unsettling interpretations of this chart. First, we have warned our clients to note how long and flat the tail is to the left. This means there is very little variation in the minimally acceptable price of natural gas across a very large range of different unconventional resource plays and, therefore, very large volumes of new supply sources. Why should a Fayetteville shale producer cut drilling and production if the price of gas is $4 and not a Bakken producer when the difference in their "cost of service" is so minimal?
The graphic would be much more convincing (but also much less accurate) if it showed a rapidly rising cost of supply curve, i.e. relatively few areas that are viable at very low prices. Such a result would leave no doubt as to where drilling and production cuts should come if gas prices fall.
Our second point to clients has been that these cost of supply curves are dynamic. They move and they move significantly and rapidly.
In particular, they shift downward as new plays mature beyond the early stages and this process can continue for a number of years. The result is a period of declining unit costs in North American unconventional resource plays and this means that the floor under gas prices is much less firm and much lower than one might expect. Obviously much lower than the $3.50 to $4 floor that this presentation graphic purported to demonstrate and which has already been decisively passed.
A supply side only approach to the problem -- cuts in drilling and production curtailment -- is one dimensional and insufficient. Until the industry begins market building here in the United States like they do for all LNG projects overseas, then we believe this price environment for natural gas is here to stay.