Friday, October 12, 2012

Finally, Something Nicer to Talk About

As our quadrennial election season morphs from the silly season to the stupid season, I recently decided to turn off the television and seek out something nicer to talk about.  I hope to have found the subject in rising natural gas prices.  Of course, no conversation these days is without debate, but at least the debate has changed from "how low will it go?" to "how high can it go?"

As the chart below (with its nice autumnal shades) shows, prices have seen a nice rise over the past month an a half.  Since September 1, spot prices have gone up 54 cents/MMBtu (+20%) and the near month futures price has gone up 80 cents (+29%).  What is also encouraging is that there finally is some spread between the spot and futures price, indicating some optimism in the market for higher prices.  The bump generally occurred at the end of September when the futures contract switched from October to November, but the spread generally has maintained since then.

Cue the debate about how high prices can go.  There are those who see it going as high as $5/MMBtu, while others don't see it getting above $4.  Weather has always been a big issue with gas prices as winter approaches and most weather predictions I've seen seem to indicate a normal winter.  But even with a cold winter, the answer is more complicated than in past years.

Coal/natural gas switching at utility plants is the big wildcard.  Substituting gas for coal has saved gas prices for the past three years and especially in 2012.  For the first six months of 2012, power generation represented the largest end user for natural gas at 37.1% of total consumption, up 32.9% from the same period in 2011, as shown below.

As gas prices trend upwards with cooler weather, some utilities will start to switch back to coal.  But the question is by how much and what that magical switching price is?  Also, will that switching price form a ceiling for gas prices or will demand from other users sustain prices?  There is a price for each power plant where coal becomes cheaper to burn than gas.  But how many utilities took advantage of low prices to buy gas forward?  While - pick a number - $3.60/MMBtu might be the point where coal is cheaper than gas for a power plant, a utility might not make that switch if it has lined up a cheaper source of gas back in June.

The other big issue is a cold winter.  What happens if cold weather sharply lowers gas storage inventories?  In the past, the answer is to drill more.  Sounds good to me, but looking back at the past three and a half years, we saw a continual increase in production and a sharp drop in rigs, as shown below.

That does not compute with historical industry logic.  There are several reasons for the discrepancy, but two of the biggest are more associated gas from oil wells and less drilling to hold leases, and therefore more drilling of higher producing wells.  Associated gas is an increasingly large piece of supply that is produced irrespective of gas prices.  As I noted last month, in 2011, 27.7% of gas produced (6.2 Tcf) came from oil wells, compared to 21.5% (5.78 Tcf) in 2010 and 19.8% (5.19 Tcf) in 2009.

If prices start to climb, producers first are going to finish wells that have been drilled but remain uncompleted.  Once that inventory is reduced, drilling activity might increase in the next year.  But I think it likely will start in areas other than Haynesville, which has been mothballed by many producers.  We may see an uptick, but it probably will begin with producers that have kept some rigs in the area.  Other producers might remain on the sideline until they can determine if prices will stabilize at an economic level.

The bottom line is that gas prices will increase somewhat this winter, but it might not lead to greater activity in the Haynesville Shale.  Still, it is a much more pleasant conversation than the elections.

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