Sunday, January 8, 2012

Oversupply and the Austerity Argument

I'm finally losing faith in the idea that high natural gas supply and continued low prices will create some sort of fiscal austerity that will cause producers to lay down rigs en masse.  Cold winters for the past two years artificially lowered supply to give the producers a break, but all that did was give them breathing room to count their blessings without breaking stride.

This winter, if you give the producers a break (a brutal cold snap that craters supply levels), it's pretty clear that they will treat it as an excuse for business as usual.  But if there is no such break this year and we have a warm winter, what happens?  I would argue that their behavior will not change dramatically.

It feels like the question I ask myself when I pull up to an intersection with a panhandler and a well-worn sign asking for help.  I want to help the guy, but if I give him money is he going to buy food or blow it on some hooch.  (Or, worse yet, is panhandling more profitable than working?  But that's another story.)

If prices keep dropping and supply doesn't decrease at normal rates, I think you are going to see some rigs go dark, but that will not lead to fundamental change, nor will it impact short-term prices significantly.  Utilities will love it and let their coal supplies swell while they burn more gas, and other big end users will happily boost their bottom lines as their fuel costs stay low, but gas producers aren't going to do much differently.  Ultimately, much to the chagrin of the thermal coal producers, utilities will probably keep a floor under gas prices to keep most producers from crashing and burning and the producers will limp on, whistling the same sad tune.

The domestic natural gas landscape has changed radically over the past three or four years.  Where it was independent producers spending their cash flow (then borrowing and selling stock) to chase the big kill, more and more you see major multi-national E&P companies starting to dominate the landscape after tying up much of the U.S. shale acreage.  Independents were highly sensitive to commodity prices, but they needed the cash flow to drill more wells.  The big boys, however, have a different approach. They have tremendous financial resources and are focused on growth of reserves and production.  They are less sensitive to the short-term swings of the commodity market.  They are very smart and are not going to do something stupid, but they aren't going to lay down their rigs and alter their long-term strategy if gas prices unexpectedly drop 50 cents.

Their eyes are focused on the horizon, not the potholes in the road before them.

On top of that, you've got companies chasing oil and liquids that are getting dry gas as an afterthought.  They are flaring it in North Dakota, but it's going to market in other places.  That activity is completely insensitive to the price of gas while exacerbating the supply problem.

Bottom line:  natural gas is a buyer's market these days and will remain so for the next couple of years.  I no longer fully buy into the argument that overflowing storage and low prices are going to lead to some kind of fundamental change in behavior from producers any more than I believe that a change in oil prices will have any impact on natural gas prices.  

Gas prices will only rise with increased domestic demand (a better economy and the closure of coal-fired electric plants) and the development of new user markets (vehicle fuel, LNG export, etc.).  Recent economic news has been positive, but it is only the beginning.  Don't expect the producers to change their behavior significantly in the face of low gas prices.  Ultimately, they likely will be bailed out in three or four years.


Anonymous said...

Four data points that are positive, though honestly I'm halfway to giving up too.

1) Gas rig counts at 2-year lows.
2) CHK seems prepared to announce a production drop ... their first, ever.
3) I believe Haynesville will complete its backlog of uncompleted wells in a few months, after which completions will slow to the pace of drilling, and you'll see a sudden drop in production.
4) While the drillers seemingly can defy economics, they can't defy physical storage limits. The economic pain when they really can't sell their gas should pause ... some of them.
5) I actually think production is moderating, it's just that demand is unusually low due to a warm winter.

Would love to hear more comments - I've half thrown in the towel too on this, maybe it's time to buy some chemical companies.

Robert Hutchinson said...

I agree that what you’ve pointed out should lead to lower overall production, especially #4. With that one, I think the operative word is “pause.” I was thinking that same thought this weekend standing in my storage unit. Each year after Christmas, Thanksgiving and Halloween, my wife goes to the after-holiday sale and stocks up on more and more decorations. Each year I tell her we have run out of room and each year she buys more stuff (big stuff too). Each year I somehow find another gap to stuff a bag, or I pile another box on top of an already precariously tall stack. Yes, when storage is full, it’s full. But I just don’t see producers changing behavior (i.e. donating boxes of old decorations to charity). I see them filling every last gap and pulling back only temporarily if the pipes stop flowing.

It’s a little off topic, but I’ve said that it wasn’t until I had kids that I began to understand adult behavior. Maybe watching my wife will help me understand natural gas producers…

I don’t know enough about chemical companies yet. With cheap gas, their cost structure will probably approximate what they would see overseas but they will be able to build new plants on US soil. The economics might be similar, but the intangibles are huge.