The price of Natural Gas is hovering just below $3, which is about the median price over the past two decades. Or is it? While the spot price has garnered lots of headlines recently for its collapse, the future price has declined much much less so. The quoted price for a year from now is above $5. Here is the history since 1990:
Clearly the spot price is very depressed relative to the future price. In fact, it is at a record percentage differential. In the chart below, I have divided the one-year forward price by the 1-month forward price. The mean spread has been 6%. You will see I included lines for +/- 2 standard deviations as well. The current relationship is more than 4 standard deviations from the mean:
At this point, I need to alert the reader that I am approaching this from the view of a generalist. Embarassingly, given that I am both a native Texan for my first 18 years as well as a resident for the past 15, I have never evolved into much of an expert on oil or gas despite my increased efforts over the past several years. I do know enough to get myself into trouble!
Kidding aside, though, I think that the "consensus" thinking is that the spot price is depressed and the future price is more reflective of reality, and I have been questioning that notion. A client of mine came back from EnerCom's Conference last month and shared his views. It was then that I realized that the leading E&P companies are all telling a pretty similar story, and it doesn't bode well for the price of gas (and the value of their reserves). Perhaps I am paying too much attention to the big Shale plays, but it appears that despite the plunge in gas prices, companies are cranking out the gas. Natural gas is more plentiful than we have imagined, and technology makes it more accessible apparently. If that's not enough, I read this week that Cheniere's (LNG) facility is importing gas despite the very low spot prices. Demand is muted, and it could return, but the real story to me is supply. Most commentary points to the large decline in drilling, citing the Baker Huges Rig Count data. Below, you can see the plunge in North American Gas Rigs in operation:
This data can lead one to conclude that production must be plunging, but I wonder if a lot of the rigs are not the marginal ones. Further, with horizontal drilling, I believe that the output per rig increases. The plunge in spot prices is attributed to a short-term decline in demand and storage at capacity. All we need is a hurricane or a cold winter or hot summer and everything will be fine! In any event, I checked some data published by the Department of Energy and found that production in total has been rather flat. For the first six months of the year, this is what it looks like:
- 2009: 10.515 TCF
- 2008: 10.213 TCF
- 2007: 9.328 TCF
I also believe that we have a situation where reserves are growing rapidly. I reviewed several conference calls from Q2 for the leading gas companies and find an alarming uniformity in what they had to say. While spot prices are quite low and would seem to suggest lower production, they are cranking it out. First, they need to crank it out. All of these companies have significant financial leverage. Second, due to hedging, they are actually very profitable. This begs the question: Who is paying $5 for gas a year out, and how long will they continue to do so?
Here are some quotes, all of which are from transcripts provided by Seeking Alpha. I have included the link to the transcript in each case (click on company name):
Chesapeake Energy (CHK): "...we expect to deliver 4% to 5% production growth in 2009, and 7% to 8% production growth in 2010, plus, increase Chesapeake's proved reserve, during '09 and '10, from 12 Tcfe to 16 Tcfe..." (CEO McClendon) and "...Finally, one note on cost trends. As you can see from our release, just about all of our production and other cash cost are down or at worst to flat from quarter-to-quarter. We continue to see some downward trend in drilling and completion costs as well..." (CFO Rowland)
Petrohawk Energy (HK): "...our priorities are significant production growth and reserve growth..." (CEO Wilson) and "... Our production came in significantly over the high-end of guidance to 483 million a day..." (CFO Mize)
Southwestern Energy (SWN): "...we will expect to have production growth of approximately 45% over the 2008 levels... During the second quarter of 2009 our horizontal wells had an average completed well cost of $2.9 million per well, average horizontal lateral length of 4,123 feet, and average time to drill to total dept of 11 days from reentry to reentry. This compares to an average completed well cost of $3.1 million per well, average horizontal lateral length of 3,874 feet, and average time to drill to total depth of 12 days from reentry to reentry in the first quarter of 2009." (COO Mueller)
Ultra Petroleum (UPL): "...Second quarter of 2009 was a difficult period for the industry, but Ultra delivered strong results. We established a new quarterly record for production of 44.5 Bcfe, an increase of 30% from second quarter 2008. At the same time we decreased our all-in-cost by 29% to $2.43 per Mcfe, and our cash costs also decreased to $1.42 per Mcfe... We ask Netherland Sewell to provide us with a mid-year proved reserve update using the more logical 2009 rules and unrestricted by us. The result is an answer almost twice what we reported at year end 2008... It is clear to us that we can grow annual production by 10% to 15% over our three-year planning period 2010 to 2012..." (CEO Watford)
XTO Energy (XTO): "...natural gas production averaged 2.352 Bcf per day, 31% increase... Of this growth, 19% comes from acquisitions and 13% comes from development...If we look at our unit cost analysis and guidance importantly, and Keith will talk about this a little later, production expense was $0.94. That compares, per Mcfe, to $1.00 to $1.05 guidance, so a substantial improvement there, and we've lowered our guidance to $0.95 to $1.00 going for the remainder of the year..." (CFO Baldwin)
So, we have increasing reserves, increasing production, and decreasing costs from these leading developers of the Shale reserves. None of this bodes well for future gas prices, though EOG Resources (EOG) CEO Mark Papa believes that the decline in Texas vertical wells will more than offset this dynamic, calling Texas "the 800 pound gorilla in the room ." Absent a major change in our national energy policy that results in a massive effort to build gas-fired electrical power plants, I believe that supply will continue to dwarf demand. Investors in the leading gas-focused E&P companies may want to keep an eye on that forward price that is enabling the companies to generate strong profits through their hedging activities.