Caveat Emptor – Be Wary of Gas Salesmen Claiming Long Term Low Prices

My years as an operating engineer has turned me into a contrarian and a pessimist who is constantly looking for signs of trouble, especially as others get excited and focused on temporary good news. My years as a critical consumer of commercially sponsored media has also made wary of sales pitches disguised as news stories. When the ultimate source of salaries is advertising, it is hard to maintain a complete independence from the economic pressures that come from people in the marketing end of the business despite all protestations of “firewalls”.

It is with those filters that I am observing the full court press being delivered by the natural gas industry to convince politicians that their fuel is a clean alternative to burning coal, to convince large scale electricity producing customers that their fuel is an abundant long term source of fuel, and to convince investors that they have cracked the code required to make geology predictable. As a skeptic, I do not just read the commercial press, but I also peruse the trade publications and expert blogs. I also attempt to glean information from the white space between the lines in all forms of media.

In the late summer of 2008, when the world experienced an economic slowdown, the price of natural gas fell dramatically because the rate of consumption was closely tied to economic activity. When their income stream slowed and manufacturers needed to stem their cash outflows, one of the easy places to take action was to reduce their consumption of natural gas that was costing more than $12 per million BTU in the spot market. Since their own products were not selling, it was a no-brainer action to slow down production and reduce energy demand. It is pretty simple for customers to shut the valves, close the throttles, and turn off the burners. In those places where natural gas is a major source of electrical power, reductions in electrically powered production and economic activity also slowed consumption of natural gas.

Though pipelines have enabled gas to find lucrative markets, the basic nature of the commodity is that it is hard to store because it takes up a lot of space per unit of energy and it is dangerously explosive if not carefully handled. In places where there is not enough pipeline capacity, the mixture that has been given the friendly sounding brand of “natural gas” is a dangerous waste by-product of oil drilling that is routinely flared to ensure it does not accumulate in dangerous quantities. Once the gas can be piped to a large energy market, it can become quite valuable since it burns cleanly with few residues in relatively inexpensive equipment like combustion turbines, furnaces, and appliances.

When fuel demand increases rapidly due to the ease with which new equipment can be installed and due to a bubbling economy, gas prices can soar. Since high prices encourage high hopes for fast profits, drilling activity will increase to provide a larger supply which can initially be sold at a wonderful profit. Unlike consumption equipment, however, drilling equipment is complicated and expensive; there is a limited supply of the rigs and the crews required to operate them. The change in supply is not quite as fast as the increase in demand. However, if the customers stop buying, the producers still need somewhere to put their gas until they can slow down the production. This situation leads to a volatile price response to a rapid reduction in demand – a behavior that is dramatically illustrated in the below graphs of monthly production and monthly average well-head prices.

Notice how the monthly withdrawals from US natural gas wells has remained relatively constant for a long period of time until a rather dramatic increase in price began occurring. For a time, price increases had little effect on supplies, but after they had been in place long enough, suppliers figured out they could make more extensive investments and recoup the additional costs. Supply began to grow, just as the consumers were forced by economics to slow down their consumption. Notice how rapidly the price fell.

There are some observers who believe that the supply has permanently increased and prices will return to the pattern set in the period from about 1980-2000. The American Natural Gas Association is spending about $80 million on an advertising blitz to convince customers and politicians that interpretation is our future reality. However, there are some skeptics who recognize that much of the increase in supply during the period from 2005-2009 has come from the implementation of a long ago discovered technique called hydrofracing that is both more expensive than traditional drilling and has a different well production profile.

When a company drills a horizontal well and then fractures the tight rock formations that keep the gas from naturally flowing, it generally gets a burst of productivity from that well. The single penetration through the earth’s crust is accessing a much larger volume of rock than a single vertical well will access, so the initial production rate can be quite high – think about the behavior of a small pipe draining a much larger bucket. However, the formation that is yielding the gas is “tight” for a reason; it is located several thousand feet underground and is under immense pressure. That pressure can cause the cracks to close as gas is extracted, even with the help of the proprietary mixture of water, chemicals, sand, and other components that were used in the fracturing process. In general, “fracked” wells can demonstrate a depletion rate that is 2-3 times as high as a traditional well.

In addition to higher than usual depletion rates, another reason that makes me believe that monthly natural gas production is not going to continue its recent rise is that producers are not terribly happy about the prices that they are getting for their recently extracted gas. They made big investments in technology and worked hard to get that tight shale gas to the surface, yet they are being rewarded with lower than expected prices. As Aubrey McClendon, CEO of Chesapeake Energy, one of the most successful users of the hydrofracing drilling technique, recently told investors on a conference call:

“Gas production will be down significantly in the months and quarters ahead.”

Several weeks ago, Mr. McClendon was featured in another story in the Wall Street Journal that discussed how rigs that had been idled by the reduction in drilling for natural gas had become more available for oil exploration and how that was reducing costs for the domestic oil industry:

Even some natural-gas producers are focusing more on oil. Aubrey McClendon, chairman and chief executive of natural-gas producer Chesapeake Energy Corp., told analysts in New York last week that he expects oil prices to remain “several multiplies above” gas prices in coming years and that he would like to make oil a bigger part of his company’s production.

“We w
ould like to find more oil,” Mr. McClendon said

As a former manufacturer in a commodity business, I recognize that any business that experiences a fall in prices remotely similar to the one that affected the natural gas industry in the summer of 2008 has to take rapid action. Business models built on $12 per million BTU gas CANNOT survive $3 per million BTU gas and are probably not even comfortable at $6. The actions that commodity businessmen take are no secret – they work their sales forces and marketing departments to increase demand and they do as much as possible to reduce overall production. (Of course, the largest and most successful suppliers will attempt to convince others to reduce production first so they can gain additional market share. They might even acquire other producers so they can control that production capacity.)

The sales efforts are pretty obvious with the “new American natural gas” campaign. Some of the efforts are not so obvious; there are stories being run in commercially supported media touting the new supplies. There have also been some interesting actions to quiet skeptics who use facts and logic to question the message that gas is now a reliable, long term fuel supply. Here is a quote describing how a man who has been producing work that questions the predicted production rates from shale gas plays explains how his column in a petroleum industry trade publication was cancelled.

In an act of extraordinary courage, a top Petrohawk executive threatened to cancel his free subscription to World Oil if the magazine continued to publish my column. Today, John Royall, President and CEO for Gulf Publishing, cancelled my November column.

Fortunately, the message controls that could be used in a time of limited access to wide audiences are losing their effectiveness as critical thinkers like Arthur Berman have the ability to publish their own work to a world wide audience. I encourage anyone who has any decision making responsibility for fuel choices to go and read some of Mr. Berman’s work at Petroleum Truth Report. Lest you think he is just an outlier, you can also read a skeptical column by John Dizard titled Shale gas numbers may not add up, published on November 1, 2009 in the Financial Times. I like the sarcastic way he introduces his ideas:

From one end of the known world to the other, which is to say from Boston to Washington and some points in between, there is a consensus among the well informed that one part of a national energy plan is in place. Thanks to the discovery and mapping of huge reserves of gas in shale formations, we have an alternative to dirty old coal, and, possibly, imported oil for transport fuel. A 40 per cent increase in the country’s gas reserves! You can thank advanced American technology for that.

Here is how that op-ed piece concludes:

Ben Dell, of Bernstein Research in New York, whose work is respected by both sides in the debate, says: “The average well deteriorates more in quality, and more wells fail, than people believe. Still, I think a rise in prices would make more (shale prospects) economic. Plenty of plays work at $9 per mcf [1,000 cubic feet].”

This less-than-expected productivity in the leading gas sector tells Mr Dell that US gas production will decline on the order of 10 per cent next year, leading to $8-$9 gas, or $3 to $4 more than the forward curve anticipates.

Wall Street and Washington had better do more due diligence, right quick, on the shale gas industry’s insider debate.