Whither The Direction Of Natural Gas Markets - Source Oil Patch.net-December 15,2011

Whither The Direction Of Natural Gas Markets by G. Allen Brooks Parks Paton Hoepfl & Brown September 14, 2011 Natural gas prices continue, as they have for the past three months, to fluctuate around $4 per thousand cubic feet (Mcf). Futures prices show more hope with a February 2012 price of $4.35 and October 2012 (a year from now) of $4.48. The market expects further improvement with October 2013 and 2014 prices of $4.92 and $5.25, respectively. This outlook is in contrast to the latest Short-term Outlook published by the EIA that says gas prices will average $4.20 per Mcf in 2011, down $0.18 from 2010’s average. The EIA forecasts the Henry Hub average price for 2012 of only $4.30, which is certainly conservative compared to the commodity markets’ view. The divergence in the outlook for gas prices probably reflects different views of economic activity. The EIA says it is now using GDP growth expectations for 2011 and 2012 of 1.5% and 1.9%, respectively, compared to the previous estimates of 2.4% and 2.6%. The new GDP assumptions suggest industrial demand for natural gas may be weaker than what others expect. Since gas demand in the electricity sector should continue to grow as almost all new power generating capacity built has been based on gas. Electricity demand, however, remains both seasonal and dynamic. Greater energy conservation continues to slow electricity’s growth along with a slowing economy. One reason the EIA maintains its somber view of natural gas prices through the balance of this year and in 2012 is because it expects gas storage to grow and approach last year’s highest end-of-injection season volume. A high storage volume, absent a very cold winter, will keep gas prices from rising materially in response to greater natural gas demand. At the end of the day, while industrial demand remains a key to future gas prices, the issue of gas supply may be the more important dynamic at the moment. The latest gas production data suggests that the surge in supply coming from the high level of drilling in gas shale formations and the hooking up of previously drilled-but-uncompleted wells continues, especially for onshore gas. The slight dip in production early in 2011 reflects the impact of the freeze-offs that occurred during the extremely cold weather in February. However, based on the EIA’s Form 914 survey of operators’ monthly gas production, we are troubled by the recent trend in revisions compared to initial estimates. If we look at Lower 48 land production, the chart in Exhibit 8 shows the initial and revised monthly estimates. During much of 2009-2010, revisions were below initial estimates, but starting last fall the pattern reversed. This trend suggests caution should be used about interpreting initial estimates in future months. The greatest challenge for the natural gas industry is to know how much gas is being added by drilling. In 2011, there has been a significant shift in the focus of drilling due to strong crude oil and weak natural gas prices. At the end of 2010, according to Baker Hughes’ (BHI-NYSE) rig count, 54.3% of the rigs were targeting gas, or 919 rigs. At the start of September, natural gas was only being targeted by 45.5% of working rigs, or 895, some 24 fewer than nine months before. For crude oil, the industry has added 299 rigs. Overall, the industry has added a net 274 rigs drilling for oil and gas this year. What is often missed by many analysts is that there are still significant volumes of natural gas produced from fields considered primarily oily or having high liquids content. Thus, the shift in drilling does not shut down natural gas additions completely. The primary culprit in the growth of natural gas production has been the relentless rise in the use of rigs drilling horizontal wells targeting gas that are associated with high initial production from shale formation wells. In preparing the chart in Exhibit 9, we used the percentage of total rigs drilling for natural gas and applied that to the number of active horizontal drilling rigs. This is a crude measure of drilling, but it helps eliminate some of the horizontal rigs drilling for crude oil. Based on that measure, from 2005 through nearly the end of 2008, there was a steady parallel rise in the horizontal rig count and gas production. That pattern ended with the financial crisis in late 2008 and resulting 2009 recession. Gas production began rising shortly after the horizontal rig count upturn. So far this year, the horizontal rig count is climbing faster than in 2010. Since the reported gas production data is lagged by two months, we can figure out what the horizontal rig count might suggest for future monthly production. The monthly gas-oriented horizontal rig count has continued climbing even in the face of a declining percentage targeting gas, suggesting gas production will also rise in the near future. But the horizontal gas rig count is now declining, on our measure, telegraphing that gas production should stop rising soon. It also suggests the natural gas market may see an improved supply/demand balance by next summer. That improvement could be delayed because the gas industry is focused on drilling shale formation sweet spots with greater output, plus accelerated completion of previously drilled-but-uncompleted wells, about 3,000. The surge in finishing uncompleted wells will ebb as hydraulic fracturing capacity expands to match the drilling industry’s need. As we look to the future, barring another economic recession, we think natural gas dynamics are beginning to shape up for better gas prices next year. As a result, we are slightly more optimistic about natural gas prices averaging higher than the EIA’s forecast. Many might say we are walking on a tightrope over a chasm with this forecast. But like all good stunt performers, we believe there are plenty of mattresses under us for when we fall. G. Allen Brooks is Managing Director of Houston-based investment banking firm Parks Paton Hoepfl & Brown. This article originally appeared in the September 13, 2011, issue of PPHB's newsletter "Musings from the Oil Patch."