Tuesday, January 10, 2012

Bullish on Natural Gas Prices?

I'm bullish on the long-term future of natural gas but less so on its price.  Chesapeake Energy, on the other hand, is dispensing the Kool-Aid, urging us to be bullish on both.  (Mmmm, I'll take cherry.)  In its most recent investor presentation, the company lays out the argument for a recovery of natural gas prices in the intermediate and long-term.

The presentation makes many of the same arguments I've made in these pages, but it leads with one I don't quite buy.  CHK suggests that once producers fulfill their requirements to hold leases and move towards liquids and oil in their production base they will have little reason to go back and drill cheap gas, and therefore prices will rise.  That makes sense on the surface, but I don't think it holds up to scrutiny for several reasons.

First, CHK assumes that all North American gas producers are like them.  CHK and other independents are chasing liquids for cash flow and to keep their stock prices from cratering.  But with the M&A deals over the past couple of years, the independent producers in the gas shales are giving way to the  multi-national majors who have a longer term view of natural gas and are fixated on growing production and reserves, somewhat irrespective of current prices.  They don't share the same logic model as the independents.

Second, CHK says it is moving out of gas into oil, but by its own estimate of rig count over the next two years, its number gas-targeted rigs will remain steady (see below).  Sure, liquids as a percentage of drilling and production will go up, but CHK doesn't expect to lay down any more gas rigs for the next two years and presumably will drill for gas at its current run rate, which, admittedly, is about 40% lower than a couple of years ago.

Third, one of the biggest issues with the pursuit of liquids is the production of associated gas incidental to the production of liquids.  Even if shale gas production falls, associated gas from liquids will continue to flood the market.

Look at the chart below showing CHK's historical and projected oil, liquids and gas production quantities.  The red categories represent CHK's natural gas production.  The bright red is shale gas, which will stabilize and go down a bit over the next four years.  But look at associated gas in dark red.  It's going WAY up with the growth in liquids.  Taking all three of the red areas together, CHK's natural gas production will increase from 2.8 Bcf/day in 2011-12 to 3.2 Bcf/day in 2015, and I believe that is net to CHK, so the gross quantities will be higher.  Eyeballing the chart, one can see that by chasing oil and liquids, the amount of associated gas these plays produce on a BOE/day basis for CHK will be nearly equal to the amount of liquids and oil combined.  Of course, even at horrible prices, the associated gas is likely to be profitable since it is the icing on the oil/liquids cake.

If CHK really wanted to make a positive difference in the gas market, it would pull back on the throttle and lay low for a couple of years.  Of course, that wouldn't make financial sense for the company because it needs the cash flow to feed the deal machine and pay down the company's debt, and such contraction is an anathema to modern business, especially for a company fixated on being #1 in everything.

I don't mean to pick on Chesapeake, but they unintentionally prove two of my points: 1) a natural gas rig count reduction by itself isn't going to lead to higher gas prices because associated gas from the pursuit of liquids will keep the gas market flooded with supply, and 2) producer behavior towards the production of gas (not just CHK's) isn't going to change in the coming years no matter the pricing crisis in the natural gas market.

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