Through the Magnifying Glass - February 27, 2012
Part of our weekly ritual is to scour through reams of charts with a diagnostic eye, looking for leading indicators of change. Let’s see; oil prices? Yes, they are up $5.00/B on the week. That’s notable and worthy of discussion; we’ll hold that thought.
[Pull out magnifying glass and look at Figure 1]
But look here—is it possible that after a three-year bull run, US natural gas production is finally starting to weaken? Yes, there is no denying that output is down from recent highs. Peaking at 65 Bcf/d in December, the meters measuring pipeline flows are now clocking only 63 Bcf/d, with hints of a sustainable downtrend (at least in our sanguine view).
[Gently put down magnifying glass]
OK, maybe it’s too early to call a trend, but it’s not too early to notice the change. Could hints of weakening output mean that a recovery in the natural gas price is forthcoming? No, not quite yet, but there is reason for gas producers to be optimistic.
To a certain degree, the production retreat we’re seeing in Figure 1 is to be expected. Two of the largest independent natural gas producers, Chesapeake and EnCana, have each announced that they are shutting in some of their production. No wonder—the price they are realizing is too low to oblige the welcome of a consumer’s pipeline. Other companies are turning their valves off too. Collectively, producer shut-ins could be as high as 2.0 Bcf/d with Chesapeake alone suggesting that it has already put a plug on 1.0 Bcf/d.
For sure, held back production can explain some of what’s going on under the magnifying glass. But shut-ins are neither convincing nor exciting when looking for that elusive, sustained down trend that would support higher prices. And you don’t have to be Adam Smith to know that the valves will just be turned back on when the price rises again. Also, North American producers are not part of any gassy, OPEC-like cartel; no participant in this free market is going to forfeit revenue and market share for long.
But wait; the most important valve being turned off is not the one in the gas field, but the one at head office. It’s the tap beneath the boardroom table marked “CAPITAL EXPENDITURES FOR NATURAL GAS,” and it’s being shut faster than a leaky toilet. Nearly every major gas producer is acting like EnCana to, “minimize capital investments in dry gas plays,” in favour of drilling for crude oil and liquids. Of course; the latter two have spiked in price (and profitability), especially in the past few weeks.
Over the past year we’ve diarized the “Great Migration” of drilling rigs to higher value crude oil and NGLs. Depressed natural gas prices due to this warm winter have only served to accelerate this logical and primal hunt for higher value products that maximize profit. Yet getting fat on oil and liquids means getting thin on being able to deliver natural gas. The mighty and prolific Haynesville—the legendary shale play in Texas that has contributed most to today’s gas glut—now hosts only 60 rigs as compared to the peak of 169, a year-and-a-half ago. Production declines are now being noted in this behemoth, a signal that the growth gig is up.
Speaking of growth, you don’t need a magnifying glass to see that there hasn’t been any upward momentum in Figure 1 since September of last year, the longest period without an increase since 2009, after the debilitating Financial Crisis. Flat output is a bullish sign in itself, noting that overall demand is expected to pick up again this year.
While it’s true that valves in natural gas fields will eagerly be reopened when prices nudge up again, it will be much tougher to twist open the all-important capital spending spigot again. Who wants to be the middle manager that suggests to his or her boss that spending money on natural gas is a wise decision? There is a big, spray-painted sign hanging off that natural gas spending tap that says, “DANGER, DO NOT TOUCH: LOW PROFITABILITY.”
As if it isn’t obvious: Why would any company divert money back toward drilling for dry gas when oil is at least 50 times more profitable on a cash basis? Microeconomics 101: A firm behaves in a way to maximize profit. That’s exactly what rational oil and gas companies are doing as they shun dry natural gas in favour of oil and liquids. In short, it’s going to take a much higher gas price to ease off the oil-spending tap and reopen the one with the natural gas label under the board table.
To be sure, the market senses that something is up (or rather down). Long-dated price contracts two-years out have ticked up $0.18 /MMBtu (4%) over the past month. Yet bloated inventories need to be burned off for higher near term prices to be realized. Yes, that will take some time, some help from summer heat, and a bit more help from a retreating production chart that won’t need to be viewed with a magnifying glass.