Saturday, November 14, 2009

Contemplating the Future

I’ve been in a contemplative mood this week. I’m thinking about the future of natural gas and it doesn’t seem as rosy as it once did without new sources of demand. Two things got me thinking: third quarter earnings reports from Haynesville gas producers and the realization that many new coal powered electricity plants will come online next year.

Reading through the third quarter earnings reports from Haynesville gas producers, I saw that most companies saw increased production or slightly lower production with a decrease in new wells. The bottom line is that shale wells are out-producing conventional wells exponentially. The production companies cut back rigs and the gas keeps coming. Good news in a way, I suppose, but not so much in this stagnant demand environment.

In deference to T. Boone Pickens, I think that gaining market share in the utility industry is the best opportunity for natural gas demand to increase. The infrastructure of functioning gas-fired power plants is already there. All utilities need to do is make the decision to burn more gas than coal. But the realization that approximately 4,300 Mw of new coal-fired electrical power production will come online in 2010 really bums me out. Power producers didn’t build these plants to mothball; they built them to burn some dirty coal. Mountains of coal have been piling up at electricity plants for the past year while many power producers chose to run on gas while the commodity price was extremely low. Now all of a sudden you’ve got a bunch of shiny new coal plants and mountains of stockpiled, already paid-for coal. What are you going to do? Burn some coal!

These are near-term concerns, but they point to the elephant in the room, which is a permanent state of natural gas over-supply in the U.S. No matter what people like Arthur Berman and Matt Simmons say, increased natural gas production is the new reality. No matter how fast the new shale wells decline, as long as they produce large quantities of gas quickly, the E&P companies are going to drill shale wells as fast as they possibly can. I’m not saying that Messrs. Berman and Simmons are wrong – I’ve got neither the technical knowledge nor the access to the data to make an educated analysis – but if shale wells produce big numbers out of the gate and pay for themselves in a short period of time, E&P companies will continue to drill them.

Internal rate of return (IRR) is an important metric that is used in analyzing the economic returns on gas wells. Because IRR is a time weighted return, the sooner you get back your investment, the higher your IRR. Even if you don’t make 4x your investment, if you get your money back in the first six months, you are looking at a juicy IRR that you can flaunt to your shareholders. That creates an incentive for the E&P companies to drill, baby, drill. The truth is that the terrestrial gas industry has always grown by drilling. It’s never hit the big one and sat back on its laurels. It’s always out there drilling the next well. But what about the rest of us? As long as E&P companies drill until there are forced to curtail production because of storage constraints, we will see depressed natural gas commodity prices.

Ultimately, the new supply paradigm puts the gas industry in a hole. Without new sources of demand, the gas industry is the guy who is getting fatter and fatter but is stuck with a pair of size 32 jeans. You’re getting more uncomfortable every day and there’s nowhere to go. If you don’t get higher penetration in the utility sector or see a bunch of new natural gas vehicles on the road, we are going to be stuck with $2 to $4 gas prices as far as the eye can see.

Producers have been able to successfully drill expensive shale wells because they can hedge gas prices out to the future. If the market participants believe that gas prices are going to be low for the next decade, the futures prices will drop and the hedging opportunities will evaporate. Most new shale gas wells are not economically feasible based on current wellhead prices. Of course then shale drilling drops. But what about the rest of us?

Increased demand is not an area where I believe the gas industry is asleep at the wheel. If there is meaningful climate change/energy policy that favors natural gas enacted or if strong incentives to switch vehicles to natural gas are created, I think natural gas demand will increase significantly. But if neither happens, we are looking at a future of artificially low gas prices and an industry with few winners. That’s what keeps me up at night.

[UPDATE 11/16/09: I pick up today's Wall Street Journal, and they're talking about some of the same things, at least on the production side. Hardly makes me feel better.]

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