Associated Gas: Waste or Treasure? June 4, 2012
A 1918 report from the Smithsonian Institution, Bulletin 102, cited that natural gas was, “the most abused, of the mineral resources in popular use,” and that the issues at that time formed, “a prominent feature in the nation-wide problem of fuel supply.”
Recent dramatic shifts in US gas production suggest parts of the Bulletin could be republished today without loss of meaning. Consumers on both sides of the Canada-US border are affected and should be concerned. And as always an investment thesis accompanies a disquieting trend.
The value of natural gas as a clean burning fuel was well recognized in the early 1900s. It was an attractive source of energy for consumers, but not attractive enough for producers (sound familiar?). An issue was that natural gas was the ugly sister of oil, the latter being the higher value and more desirable product. As well, there was no way to get natural gas to population centers, because the technology to weld high-pressure pipelines would not arrive until the 1930s. Consequently, “Associated Gas,”— so called because it accompanied the production of oil as a byproduct—was blown into the atmosphere raw, or flared as waste.
Consider that there are three broad sources of natural gas production in North America today: Conventional Reservoirs (all the old stuff), Shale Gas (all the new stuff post-2006), and Associated Gas (the stuff that comes out of the well with oil). Figure 1 shows how the mix in the US, the dominant continental producer, has changed in six short years. Our projection to 2013 is also illustrated.
Like videocassettes being pushed out by new age DVDs, output from the Conventional Reserves segment is in terminal decline. Neglected by drilling rigs, this once mighty source of gas production is now retreating linearly at a pace of 3.6 Bcf/d every year. Canada’s retreat is proportionally more aggressive; as we discussed in last week’s ARC Energy Charts, WCSB gas flows in 2012 could wane by 16%, or 2.3 Bcf/d.
Shale Gas was almost non-existent half-a-dozen years ago. Combined with Associated Gas, the two composed only 11% of US production in 2006. Since then, the shale surge has become an old story, though it’s still staggering to see how fast it has pushed aside the conventional segment and grown the top of the stack. Today, US consumers depend on shale plays for one-third of their gas needs, or 23 Bcf/d. However, the situation is fluid. Prices under $2.50/mcf, induced by the excessive production, have sent drilling rigs flocking toward higher value oil plays. Consequently, six out of seven big shale plays are either producing steady or are in decline. Cumulative shale output is tenuously level. In the absence of sudden price appreciation, we expect this segment of total US production to record a gentle decline of 0.6 – 0.7 Bcf/d per year through to the end of 2013.
Six years ago, in 2006, there were 300 rigs drilling for oil in the US; now there are 1,400, with most chasing light tight oil (LTO). No wonder Associated Gas is the fastest growing slice of the natural gas complex. It’s hard to see in the scale of Figure 1, but production has increased from a fairly steady 3.8 Bcf/d to almost 9.0 Bcf/d over the same period. If drilling for LTO continues to grow at the pace of 32 new active rigs per month, we expect associated gas to increase by 3.0 Bcf/d and 2.6 Bcf/d, respectively, for each of the next two years. That’s a lot, but not quite enough to fill in for declines from the Conventional Reserves segment and uphold top line production.
Which brings us back to the Smithsonian Bulletin. The backbone of conventional natural gas production is in decline and the only thing trying to prop up supply is a byproduct of oil. It’s an unsettling dynamic – to think that a vital commodity that heats millions of homes and powers industries is, at the margin, now considered a waste stream by its producers. A blunter assessment is that consumers of this clean-burning wonder-fuel are embracing it in greater quantity, while producers are only inadvertently supplying society’s incremental needs from a waste stream that is not sustainable in the long run. This is neither desirable nor sustainable for a high-value commodity that is a, “prominent feature in the nationwide problem of fuel supply.”
Only callously then does this situation lead to an investment thesis. In the face of economic weakness, the price of WTI oil has timidly retreated to the low-$80 range, approaching the ‘discomfort zone’ for producers who are dispatching rigs in the pursuit of LTO. A sustained drop in the price of oil is likely to moderate drilling for LTO, and reign in the growth of Associated Gas – the last pillar struggling to hold up continental natural gas production. So, if oil prices weaken and stay weak, the argument for higher natural gas prices only strengthens.