Although it is tempting to think that the inventory reports this summer have been bullish, I would argue that hasn’t been the case until the very latest report. If we had an early summer with normal temperatures, inventory levels would have been increasing at a faster than normal pace. With this in mind, the inventory reports were actually slightly bearish through the end of June. Additionally, the stock of inventories is 300 BCF above the 5 year average and 550 BCF above the 10 year average. That being said, there are a number of factors that are now starting to weigh toward the bullish side of the ledger in the natural gas market. First of all, at least in the short term, are the credible predictions for a hot summer and an above average hurricane season. The second reason to lean bullish is that as we move further and further away from the 2008 price highs, there will be less and less gas that was previously sold forward at prices above $7/MMBTU. Finally, we must reconcile that the inventory reports have become increasingly neutral over the past 6 weeks in spite of the increased drill rates. This is potentially the first hint of a treadmill effect which will be the Achilles heel of shale gas.
Issue 1: Hot and Wet
While hot weather and hurricanes have a transitory effect, they still have a major presence in market psychology. In fact, I would wager that most or all of the price increase since May has been due to weather fears. Although a premium has already been built, it is likely to continue for at least another month. Hurricane activity peaks in early September (https://www.nhc.noaa.gov/pastprofile.shtml), so I wouldn’t be surprised to see another push higher in price due to worries about the upcoming cooling season and hurricane season.
Issue 2: $7 gas is a distant memory, $10 a dream.
How natural gas production companies must pine for the summer of 2008. Not only was spot gas $13 /MMBTU, but companies could hedge production out as far as the eye could see above $10. Bonanza! Alas, the opportunity to hedge production above $10 was a brief dream. By August 2008, if you needed $10 to profitably produce you were done with your hedging activities. Prices for winter months continued to hold above $7 for a much longer time. As recently as Oct. 2009, $7 gas was only 15 months away in the futures market. However, to find $7 gas in the current natural gas forward price strip, one has to move all the way out to December 2016! I’m not saying it doesn’t happen, but the percentage of production that is hedged 6 years in the future is going to be low. What that means is that producers of gas who need a price over $7 to be profitable will continue to phase out production as their hedged contracts come to pass. This will leave us with almost exclusively shale gas producers to provide new supply, which takes us to issue 3.
Issue 3: Inventory reports are neutral, but drill rates are elevated
The interaction between drill rates and inventory reports is complex but the underlying trends are fairly simple. As drill rates fall, the decline rate of existing wells due to depletion eventually begins to outstrip the supply from new wells that are being drilled - and net supply falls. We saw this dynamic occur in the latter half of 2009. Drill rates below 750 [Figures 1 and 2] could not keep up with the depletion of existing wells. It now appears we reached a nadir in production in December at 71 BCF/day. When drill rates rise, as they quite precipitously did from January to April of this year, supply from new wells becomes greater than supply lost from depletion and net supply rises – production in April was almost 74 BCF/day.
Figure 1 here: Natural Gas rig count, 06/2009 to present (source Baker Hughes)
Figure 2: Shows supply and demand disposition after backing out the effects of degree days on natural gas demand, 06/2009 to present. Red areas indicate times when underlying supply exceeds underlying demand and green areas indicate the reverse. (Source: EIA, CPC)
Since April, while drill rates have held more or less constant in the upper 900 range, something interesting has happened with supply and demand disposition – it has fallen into balance. When drill rates increase and then hold at an elevated level, one would normally expect supply to continue to increase, so what has happened? One possibility is that the increased drill rate had only a temporary effect. How could this be possible? Marginal supply is coming almost exclusively at this point from shale gas: https://gis.bakerhughesdirect.com/RigCounts/default2.aspx. Even though the new shale gas has a “100% success” rate and astronomical initial flow, its Achilles heel is its equally astronomical depletion rate! If a well depletes at 30% month over month it quickly goes from a giant to a peon [Figure 3].
Figure 3: Hypothetical monthly production of a shale well with initial flow rate of 30 MMCF/day and a 30% monthly decline rate. Note that the well produces almost 1 BCF its first month but only .014 BCF in its twelfth month.
If these decline rates are close to accurate, then “increasing supply” for shale gas essentially means “increasing drill rates.” For more traditional wells, if you increase drill rates to a new level and hold them there, supply will gradually continue to increase because depletion rates are low. In the world of shale gas, it may be that supply will increase impressively when drill rates are increasing, but then level off quickly once drill rates hold at the new higher level. Since the new shale gas plays (Haynesville, Marcellus) represent only 6% of national supply, they must offset depletion not only from their own fields, but from the other 94% as well! It seems as though constant drill rates below 1000 rigs may not do the trick. Looking forward, it is only a matter of time before we exhaust current rig capacity. If there was one factor that I would list as a potential widow maker to natural gas bears, it would not be hurricanes and hot weather – it would be a chokepoint in horizontal drilling capacity.
Conclusion
Shale gas is huge and economic activity is tenuous. I understand the bearish argument, and we will continue to see Haynesville and Marcellus ramp up production levels in the coming months and years. But these fields are fighting an increasingly unilateral and uphill battle, and there will be times when it could be profitable to risk defying their impressive assets and reserves. Coming into a hot and stormy summer with neutral supply and demand numbers could be a good time to look for a counter trend rally in natural gas prices.
