Who is Eating at the Petroleum Club? - January 16, 2012
“Challenging” is far too polite a euphemism to describe the plight of North American natural gas producers. Their situation has now gone into the “red-zone” and can be gingerly described as “existential.” Gas traders transacting at the US benchmark Henry Hub saw action below $2.70/Mcf last week, prices not seen since the doldrums of 2009. Canadian prices are equally threatening, now below $2.60/Mcf. Yet more than ever, if this industry is going to remain viable, the present circumstances argue that gas prices must strengthen to between $5.00 and $6.00 in both markets.
For a lot of companies, cash flows derived from producing gas have now crossed over to the negative side of the ledger. Lunch time talk by executives at North American Petroleum Clubs is dominated by more budget cuts. The discussions are sobering and there is nothing like distress to reinforce the inevitability of a supply decline.
Proactive budget slashers are skipping the Pete Club buffet altogether. Talisman’s John Manzoni, the CEO, announced last Tuesday that they, “are reducing capital spending in dry gas plays in North America,” noting that their $500 million cut (11%), “accounts for the majority of the decrease [in capital spending] over 2011….” Anecdotally, we know Talisman’s announcement to be harbinger of others to come. Over the next few weeks we expect to hear more companies announce that they are fleeing from gas.
With these existentially low prices, the amount of cash flow generated to keep the natural gas business viable will continue to dry up. In fact, late last year we drew attention to how much money American gas producers needed to spend in order to keep their productive capacity steady. Annual volume declines are now estimated to be greater than 22 Bcf/d per year, requiring an increasing amount of up-front capital to counterbalance the pull. Based on that article, several people wrote in and asked the logical question, “What gas price is needed to counterbalance cash flow against required investment in drilling.” In other words, given what we know about the operational and financial performance of gas producers, what is the threshold price that balances the industry’s funding gap?
Using third quarter 2011 financial and operating statistics, we estimated that between July and September, the cash flow generated from all US dry natural gas production was about $12 billion, but that maintenance capital needed to offset declines was on the order of $22 billion – a run-rate deficit of about $10 billion per quarter. And that $10 billion shortfall was when gas prices were averaging a bit over $4.00/MMbtu! Since then, prices are down 32% and the shortfall is now tracking over a $13 billion per quarter run rate.
Back to answering the question at hand: Based on calculations that balance industry cash flows against investment required, we estimate that the natural gas industry needs $5.80/Mcf, priced at Henry Hub in order to maintain long-term sustainability. That answer is also consistent with the average supply costs of between $5.00 and $6.00 required for many resources plays (eg. Barnett, Haynesville, Montney) to achieve investment returns that are attractive enough to spend more capital. Current low prices will accelerate the move to this $5.00 and $6.00 threshold range. However, many argue that the industry as a whole can produce and replenish reserves much cheaper than that range, but those are the guys not eating at the Petroleum Club.