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Commentary

US natural gas prices still too low to support adequate production

31 Aug 2014 by Jim Fickett.

Experienced US exploration and development companies are still reducing natural gas production in favor of liquids. And the natural gas in storage is at a 12-year low. Nothing is certain, but the price is likely to continue its two-year uptrend.

For several years the production of natural gas from US shale has been more of a Ponzi scheme than a business, with continual infusion of new capital required to keep the drills operating. However a recent study from the Financial Times suggests this period is over, and cash flow from operations is now sufficient to cover new investment; i.e. free cash flow is finally positive.

Cash earned from operations by 25 leading North American [oil and gas] exploration and production companies is expected in aggregate to exceed their capital spending next year for the first time since 2008, according to an analysis by Factset for the Financial Times. …

As production has grown … the industry has been reliant on sustained inflows of capital to finance its drilling programmes – through borrowing, equity issuance and asset sales.

Some critics have described the industry as a “Ponzi scheme”, relying on the excitement over the shale boom to attract new investment, and warned that it could collapse when companies ran out of financing to drill more wells. However, shale companies’ finances have improved rapidly as a result of a shift by many away from natural gas towards more lucrative oil production and a pick-up in natural gas prices after they fell to 10-year lows in 2012.

Analysts’ consensus forecasts now indicate that the leading shale companies’ operating cash flows in 2015 will show an excess of about $2.4bn over their capital spending – compared with a shortfall of about $32.2bn in 2012, and $8.8bn last year.

In 2012, only two of the 25 leading companies could cover their capital spending from their operating cash flows, and this year that number is expected to rise to 10.

The main reasons cash flow has improved are:

  1. Increasing efficiency through incremental technological advances
  2. A gradual migration away from natural gas production to oil and natural gas liquids
  3. A two-year trend of gradually rising natural gas prices

So, given that production costs have gone down and gas prices are up, is the market in balance? Not yet.

Although every producer's quarterly reports brags on profitability and low costs of production, actions speak louder than words, and almost all experienced producers are still shifting their production away from gas and towards liquids (see, for example, the company websites of Chesapeake, Devon, Encana, Exxon, Shell). That strongly suggests that the price still needs to rise to even maintain production.

As companies have decreased production, the amount of gas in storage, measured as smoothed months of supply, has dropped to an unusually low level.

This suggests, again, that the incentive to produce sufficient gas has not been adequate – i.e., the price has been too low.

There is one other point which supports higher prices in the future – planned exports. LNG export terminals will start to operate in late 2015, and exports may take approximately 3-4% of production by 2017.

Demand is very likely to be high. For example, Japan still has not restarted any nuclear reactors, and is a major gas importer. The price of shipborne liquefied natural gas in Japan is currently $16.75/mmbtu, more than $10 above the US Henry Hub price, while liquefaction, shipping, and re-expansion costs $2 to $3/mmbtu.

Some have predicted that the rest of the world will join the US soon in producing large amounts of shale gas. This is not happening yet. Two of the countries that have pushed hardest to develop shale gas resources have very little to show for it so far. In Poland,

Both domestic and foreign operators have drilled 65 exploration wells since mid-2010.

However, the geology has proved more difficult than originally predicted and none has yet flowed gas at a commercial rate.

And in China,

With more than 30 trillion cubic metres of recoverable shale gas, China has the largest reserves in the world, almost 70% more than in America, home of the shale-gas revolution. [actually, this comparison is for technically recoverable resources, not reserves]…

American shale seams are mostly found in easily accessible areas at quite shallow depths, and formed of rock that is easy to fracture. China’s are mostly deeper, often in inhospitable areas, and made up of rock that resists American fracking techniques. Worse, some of the biggest reserves are in regions, such as Sichuan province, that have been convulsed by seismic activity or are short of water, making fracking even tougher.

China’s two biggest state oil companies, Sinopec and China National Petroleum, have been fracking furiously, but so far only Sinopec has a commercially significant shale-gas project up and running, in Sichuan’s Fuling district. It claims the field will yield 5 billion cubic metres next year, compared with just 200m cubic metres of shale gas produced nationally in 2013. Few other large shale fields are set to come online, while other natural-gas projects have missed their production targets.

Hardly surprising, then, that in May China signed a $400-billion deal with Russia’s Gazprom to import 38 billion cubic metres of natural gas a year over the next three decades.

All in all, it will be several more years before exports influence the US market significantly, but exports will probably provide a small upward force on prices beginning in perhaps a year and a half.