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By Robert Rapier on Aug 13, 2014 with 31 responses

Why Natural Gas Prices Collapsed

Over the course of the next two columns, I plan to finish up the recent look at BP’s Statistical Review of World Energy 2014. The final two columns will focus on renewable energy, and carbon dioxide emissions.

Today I want to provide an update on the natural gas picture, as prices declined sharply at the end of July. I have laid out the argument since last winter that because of the deep inventory hole that developed over the course of the exceptionally cold winter, natural gas prices would remain high relative to last year, and that as a result natural gas producers would likely report higher year-over-year profits. (For background on the inventory picture, see my February column Natural Gas Inventories are Headed Toward Zero).

First, let’s look at what natural gas prices have done since winter. The chart below from the Energy Information Administration (EIA) shows that natural gas prices have been higher this year than they were either of the past two years as expected, but that toward the end of July the price fell sharply.

Seasonal Natural Gas Analysis

So what has happened? Two things. The first is that producers have been producing at higher rates than they were either of the past two springs. Thus, on the supply side the situation looks pretty good. In fact, the EIA recently reported that natural gas production in the Marcellus Shale region had exceeded 15 billion cubic feet per day (Bcf/d) for the first time ever.

But the bigger issue — as it was in the winter — has been unseasonable weather. Generally in the summer demand for natural gas spikes as utilities react to increased loads from air conditioners. This summer has been like this past winter — cooler than normal. In fact, this summer is flirting with record cool temperatures across many cities across the US, and that has reduced the demand for natural gas. This has meant that inventories are recovering faster than expected, and that has reduced the fear premium that existed in early spring. Gas inventories are still below normal for this time of year, but the potential for more cool weather has investors betting that inventories will be in good shape once high demand season begins:

ngs

Natural gas producers have been reporting higher year-over-year earnings as I expected, but many have sold off over the past month due to concerns about shrinking margins. Natural gas prices have recovered some of the year-over-year premium in recent days — the current price of $3.97 per million British thermal units (MMBtu) is $0.63/MMBtu higher than the price a year ago — but if the summer continues to be cool it is much less certain that premium will be maintained.

One word of caution though is not to be confused by natural gas seasonal pricing effects. When I argue that natural gas prices will be higher, I have always tried to make it clear that I am referring to year-over-year prices, which will impact year-over-year profits for gas producers. But July gas contracts will generally be cheaper than February contracts because of seasonal demand. So you can expect in most cases gas prices to actually decline between winter and summer, but the year-over-year differential is what is important.

Conclusions

My thesis last winter was that low inventories would lead to higher year-over-year natural gas pricing, and that has proven accurate through the end of July. Year-over-year profits for gas producers have been higher. But a cool summer has meant that inventories have headed toward normal levels faster than expected.

Weather is always a short term risk factor in the natural gas market. If this winter resembles last winter, we will again see high natural gas prices, especially if we don’t recover to normal inventory levels by the start of injection season in ~mid-November. (Inventories are still 20% below the 5-year average for this time of year). But as recently as 2012 we had an unseasonably warm winter, and natural gas prices collapsed in response.

If you are a long-term investor in natural gas companies or infrastructure providers, these seasonal fluctuations are not important. Over time, they will average themselves out, and there are a number of factors that argue that natural gas prices will move higher than may be implied by natural gas futures prices.

Link to Original Article: Why Natural Gas Prices Collapsed

By Robert Rapier. You can find me on TwitterLinkedIn, or Facebook.

  1. By GreenEngineer on August 13, 2014 at 4:56 pm

    Robert,

    This post is a good context to ask a question that has been bugging me for a few weeks, based on this EIA report.

    The charge indicates that, broadly speaking, the oil and gas producers are losing money in the recent boomtimes, to the tune of ~$100 billion per year for the last couple of years.

    They’re making up the difference with debt and asset sales, but this is obviously not a sustainable trajectory.
    Also, it is my understanding that fracked wells (which I assume is what most of this investment represents) often deplete very quickly, requiring rework or new wells to be drilled on a pretty much continuous basis in order to maintain production. If so, this isn’t a situation where they are taking on debt to make a long term investment that will pay long term dividends.

    What’s your take?

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    • By Robert Rapier on August 13, 2014 at 9:59 pm

      It’s not a universal truth either way. There are companies that are over-leveraged and at great risk should production falter. But there are also companies making money with gas in the Marcellus at $3/MMBtu.

      Also, in some cases there is a real misreading of up front costs that will be depreciated over a number of years. If a company spends $100 million this year to generate $25 million in profits per year, it is true that they spent $4 to make $1. But then if they do that every year for the next 10 years, it’s a different story altogether. The big question is how long can they do it, and will that be long enough to for those investments to pay off?

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      • By Forrest on August 14, 2014 at 8:09 am

        So, companies are bullish upon investing in the fracking business and invested heavily within new equipment. Accelerated depreciation benefits imply a great loss of income per IRS reporting, but the accounting is not an indication of true profitability for future. Once the equipment book value is depreciated the ROI will zoom. Meaning the cost of equipment depreciation is not actual/real cost. If it were the wind turbine investments would be a real loser.

        The companies that are highly leveraged would be susceptible to gas wars, whereupon competition will attempt to drive others out of business. This phenomena ever present in our entertainment/information services, phone service, and air travel business. Business long term strategy includes such moves as the ExxonMobil merger to consolidate competition for market influence. As you advise, very bad for business to make a bad supply demand forecast and bad to have players over produce supply. Profit is impacted highly by such bad moves. For business it’s better to have an unstable condition of a necessary commodity. Economics refer to this as inelastic demand, in which prices are greatly effected by market. All of investment and production looking to “manage” the market to maximum ROI. A portion of this strategy is silent collusion to act “responsible” for the good of invested groups. Consumer groups including federal actions need to protect renegade business that exploits created opportunities to make a buck. These actions serve to keep markets true, honest, and protects consumer interests. Mature markets tend to get lazy with the same old suppliers getting fat without much innovation. This is reason #1 why government should not be a supplier of products or services. Education, health care, and welfare being examples of future poor performance (value) of investor money.
        Also, consumers need to step up and communicate need to diversify inelastic energy needs. It’s not good to rush to solutions of natural gas per current low cost and high supply if the easy solution will result in over reliance, decrease in fuel flexibility, and possible exploitation (lack of true open market competition). As I’ve indicated above, players all win if consumers lose. We need active management to protect true open market influence. The utility doesn’t care if prices skyrocket, they just want their percentage and guaranteed market. For this reason we need coal power to maintain leadership in power production. Also, it’s troubling when understanding your article on natural gas market and the huge natural variability of energy needs when reading other articles claim we will lose our reserve energy supply upon green energy. That the smart grid will balance our energy needs when the wind doesn’t blow and sun doesn’t shine. Isn’t this a pipe dream as within reality we have huge variability of energy needs that green energy supply will only make worse. It’s very attractive to dampen energy costs spikes per injection season of natural gas and viewing piles of coal and corn. Can anybody predict wind or cloudy days? How big a battery required to level annual power needs? But, as you describe year to year needs vary as well.

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      • By GreenEngineer on August 14, 2014 at 1:49 pm

        If a company spends $100 million this year to generate $25 million in profits per year, it is true that they spent $4 to make $1. But then if they do that every year for the next 10 years, it’s a different story altogether. The big question is how long can they do it, and will that be long enough to for those investments to pay off.

        Yes, clearly this is the central question. But this hinges upon the behavior of the fracked wells which tend deplete quickly, at least according to most of the credible (i.e. not obvious breathless industry boosters) assessments I have heard.
        Obviously this won’t be true for all wells, or all companies. But the central question is what level of ongoing investment is required to keep production going. Investing $4 to make $1 is fine, if you can keep making that $1 for several years. But if you have to invest $2 next year (i.e. rework) to keep that $4 investment continuing to produce $1, this is not a winning proposition in the long term, although it can (and possibly is) a very strong basis for an investment bubble.

        So in many ways this boils down to a technical question about fracked oil and gas wells. Do they, in general, deplete quickly?

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        • By mbutu o mally on August 14, 2014 at 2:12 pm

          You plot production on a curve and you include the rapid depreciation on that curve. Likewise you project your costs relative to production and your prices relative to your ability to hedge production. You then discount the expected cash flow to determine your NPW. If the NPW when the cost of drilling is taken into account is negative you don’t drill. There’s a whole industry inside the oil and gas industry about preparing accurate forecasts and accounting for current and future costs and prices. The rapid depletion is assumed in the calculation, the bigger issue is if initial production isn’t as high as forecast, or you drill a dry hole.

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          • By GreenEngineer on August 14, 2014 at 2:29 pm

            That is of course the way things are supposed to happen, if the industry is being sensible and prudent. The amount of boosterism and hype around shale oil/gas, and the enormously rapid rate of expansion, leads me to doubt that these analyses are being performed, or being performed with integrity.

            Wall Street also has a role in this. They are earning enormous fees by arranging financing for these projects – which is all well and good if they are selling good investments. But during the run-up to the 2008 crash, securitization was being used specifically for the purpose of hiding risk, in order to make bad investments look good. I am concerned that the same thing is happening now.

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            • By Forrest and Jan Butterfield on August 15, 2014 at 6:47 am

              These are concerns or speculations that are extremely hard for average investor has little privy to

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        • By Robert Rapier on August 14, 2014 at 2:25 pm

          I meant to address this. Yes, wells tend to deplete rapidly in the first couple of years, and then the depletion rate is much lower. But, there are numerous drilling sites identified, and companies have a large backlog of them. Keep in mind that rapid depletion has always been the case, yet the Marcellus has gone from about nothing to 15 Bcf/d in a short period of time.

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          • By GreenEngineer on August 14, 2014 at 2:32 pm

            But, there are numerous drilling sites identified, and companies have a large backlog of them.

            Unless I am entirely misunderstanding you, I’m not sure that this is relevant. The shortage is not, as far as I know, one of potential well sites. The issue is whether or not these wells, on average, redeem the cost required to drill them and rework them. If the industry is actually making back its investment on most of its wells, then fine. But if they are being forced to reinvest all of their income, plus additional debt, just to sustain their production, then they are in a red queen’s race.

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            • By Robert Rapier on August 14, 2014 at 2:36 pm

              “The shortage is not, as far as I know, one of potential well sites.”

              The issue is that this is why production continues to expand when so many said it couldn’t because of those rapid depletion rates. If you have rapid depletion in the first two years but numerous sites to drill, you can potentially expand production for a long time.

              As far as whether the wells pay off, the oil and gas industry has lots of people who do these sorts of economic analyses. Doesn’t mean they are always right, but it’s not as much guesswork as some have implied.

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            • By GreenEngineer on August 14, 2014 at 5:27 pm

              The question is, are these economic analyses being done and done honestly?
              The financial services industry and the mortgage industry had a whole toolbox for making analogous predictions and estimations. Some of those tools (e.g. the gaussian copula) were either broken by design or egregiously misapplied. Whether this was intentional or not is immaterial, but the fact is that these models were used in such a way as to provide the answers that their users wanted to get, to validate the continuation and acceleration of the mortgage securitization market, rather than to provide a realistic assessment of risks.

              The frenzy in this market resembles the frenzy in the mortgage market five years ago (lots of activity, lots of “everything is roses” hype, very little sober and realistic discussion of upsides and downsides), and we know that Wall Street is extensively involved in setting up and financing these deals. That makes me very suspicious.

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            • By GreenEngineer on August 15, 2014 at 1:46 pm

              Another indication of the bubble-like economics of shale plays:
              http://www.propublica.org/article/chesapeake-energys-5-billion-shuffle

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            • By Forrest on August 15, 2014 at 2:37 pm

              The article just a hack piece. It’s an attempt to smear the fracking industry per sensationalism and politics of anti fossil fuel activists that don’t want competition to their wonderful ideas. Some truth of course, but it’s not business nor scientific based article. It’s an just an emotional hack piece to gin up hate. The fracking industry has a long history of success. It wasn’t even on the radar of being a potential environmental problem until the discoveries of large natural reserves could be tapped. It took some time to gin up the propaganda as the activist had nothing to start with. Funny, since the practice has a long history. It is amazing how these web sites can reverberate with same thinking folks all supporting each others nonsense, story telling, and prejudices. Not good for country to have so many with bad thinking skills, animated with such energy and “wisdom”. Citizens are helping themselves to bad information on purpose to support their biases. The poor are full of such self indulgence to patronize their bad thinking. Schools, also, appear to have fallen away from the open minded liberal thought process. Now, it’s politics and indoctrination. Woe.

              This comment was credible.

              The Plainsman

              I’m sorry, but this article is simply not believable based on the facts you’ve presented in your exhibits. The only thing I see here is that neither you nor anyone around you knows how to interpret a royalty check and none of you (including your so-called executive at a rival company) know a single thing about gas marketing. I think CHK is a terrible company with incompetent people-at all levels. But, this is a story that is not true on it’s face based on the evidence you presented yourself. You only proved you don’t know what you are talking about. It is a damn shame that people are so gullible and willfully uninformed. Please feel free to contact me if you’d like some real information on how to read checks and the essence of gas contracts. I read, written and approved thousands over a 20 yr career.

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            • By GreenEngineer on August 15, 2014 at 2:40 pm

              Oh please. You’re going to have to do better than that to refute a well researched article by investigative journalists. A shotgun blast of assertions and aspersions doesn’t begin to cut it.

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            • By Forrest on August 16, 2014 at 9:00 am

              I reread the link and other articles. I’ll keep my initial assessment. The author self describes as climate change specialty. The article has links to latest health studies and investigation on Indian reservation being cheated per royalties of mineral contracts. The story has personal stories of woe. This is typical trick of politics to garner maximum sympathy while disclosing little tangible evidence, i.e. we were hoping to pay off the farm. Also, the trick of using worse case scenario to denigrate the entire industry just another politician or community organizer trick to gin up hatred and bias. There is no opposing viewpoints, nor expert witness explanations. The author plays lose with the facts and paints per far left viewpoint of being helpless upon the savages of evil business per capitalistic system. No disclosure that U.S. system of justice, fair trading, information rated best in world. The CEO McClendon was fired per stock investors and the company is currently doing great and rated a good stock pick. Think of all the “free” lawyers willing and able to bring case on anything that can be proven as unfair. How about the huge data upon professional investment analysts, stock holders that have maximum interests in company operations especially CEO operations, SEC filings, Department of Justice oversight, IRS filings, and file cabinet of regulations. Also, don’t forget the royalty receivers have organized for maximum influence NARO. To get a realistic handle on ability of business to trick consumers per illegal profit. Remember the successful lawsuit against fuel supply business that hadn’t accounted for temperature change and the minute expansion of fuel?

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            • By GreenEngineer on September 11, 2014 at 5:17 pm

              This report has about 200 pages of statistics and graphs which claim to support my basic thesis, that the fracked wells decline so fast that they will generally not pay for their own investment, leading to a production dynamic that is ultimately unsustainable.

              I freely admit that I have not read this in detail, and I am not really knowledgeable enough to assess it at that level. I would be curious to know what you thought about it. The author’s biases are clearly on display (he’s a Post Carbon Institute fellow) but he’s also a veteran petroleum geologist so his bias may be well founded (or not).

              http://shalebubble.org/drill-baby-drill/

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            • By Robert Rapier on September 11, 2014 at 10:36 pm

              But if you at the financial statements of some of the companies operating in the shale plays, you can see that they are getting better and better. Look at Cabot for instance. It is certainly possible that some companies will over-leverage and not be able to pay off their debt. But I can say with near certainty that a lot of companies will navigate this just fine. Some people assume that none of these companies know how to do any sort of modeling or financial analysis.

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            • By GreenEngineer on September 12, 2014 at 6:03 pm

              Robert,

              There is no question in my mind that what you are saying is in the realm of the possible. Certainly there are modeling and analysis tools which could be used to chart a moderate, reasonably profitable course over the next couple of decades.
              But I question to what extent these models are being used, and being used honestly.

              As has been said, all models are wrong, but some are useful. This means that the ultimately utility of these models comes down to human judgement and clarity of understanding. During a wild-west growth mode, which fracking is clearly in, there are strong financial and psychological incentives to embrace models which tell you what you want to hear and to discount those that tell you the opposite.

              The world’s financial institutions also know how to do modeling and analysis. That did not save them from bankrupting themselves in the 2007-2009 timeframe. In fact, those models were used to bolster their confidence, to rationalize taking greater and greater risks. Now those same institutions are offering those same types of financial instruments to the fossil fuel industry.

              I am sure that some companies are taking a moderate and conservative path through this process, and resisting the urge to pile on investment for the sake of maximizing short term profits. Those are not the companies that concern me. I am equally sure that other companies are doing the exact opposite, making the maximum possible investments for the maximum possible short term returns, and justifying this behavior based on a selective reading of the models.

              The real question, in terms of the future, is the proportionality between these types of companies. The tendency to embrace an opportunity to make a profit and to ignore or discount risk is both very human and very much in vogue in American corporate management. Do you think that the directors of the world’s fossil fuel companies are that much more conservative, sober, and sensible than the average person?

              I guess time will tell. The thing about bubbles is, they always burst. So we will see.

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  2. By rdcormia on August 17, 2014 at 4:53 pm

    A dumb (or naive) question – would a spike in oil prices to above $125/barrel have an ‘upward pull’ on natural gas price (US) through a ‘BTU ratio’, which appears to influence the price of natural gas outside the US, and particularly in Russia and Europe?

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    • By Robert Rapier on August 17, 2014 at 5:04 pm

      It’s not a dumb question at all. I have looked at this over the years. Prices were more connected before the explosion of shale gas in the US. But because we are export limited on natural gas (at present), and oil and natural gas are not very interchangeable in the US, it would take a sustained higher price before we saw that kind of shift. Ultimately it would encourage more LNG export terminals, and more natural gas vehicle conversions. But those things take some time.

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      • By rdcormia on August 18, 2014 at 12:32 am

        Thanks for the considered response – I had stitched together these points from various reading. Part of my question stems from a concern that natural gas prices rise in the next 3-5 years, making gas-coal switching less likely, and natural gas generated electricity more expensive. Cheap natural gas makes for transportation solutions too.

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  3. By Philip Lewis on August 20, 2014 at 3:01 pm

    I agree that short term weather patterns could be misleading and should be ignored. Which is what caused the temporary depression of gas inventories, and is irrelevant to the July price crash IMHO. That was caused by skyrocketing U.S. production. E.g., the Utica Shale, an immature, and not particularly impressive shale play, has already gone from near zero to 1.3 Bcf/d production. The gains in Marcellus are twice as big. And then there are all the other basins. This winter’s very modest (considering the record breaking cold) run to $5 was enough to bring out the drill bit, which combined with continuing rig efficiency gains is producing another glut of natural gas. Natural gas prices are going lower and will not go above $5 (except for short term spikes) for a very long time.

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    • By Robert Rapier on August 20, 2014 at 11:08 pm

      You are only thinking about supply side though. There are some very big demand side drivers, three of which are the commencement of LNG exports, the phase out of coal in electric power generation, and new manufacturing capacity that has migrated back to the US to take advantage of cheap natural gas.

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      • By Philip Lewis on August 21, 2014 at 1:56 pm

        It will be quite a few years before LNG and Power Generation catch up to the drill bit. About 2022 IMHO. Not going to happen this summer.

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        • By Robert Rapier on August 22, 2014 at 6:46 pm

          But the natural gas markets move on perception. LNG and power gen don’t have to catch up; they merely have to be trending in that direction, or enough projects have to be announced that it’s clear a lot of the excess supplies will be used up. Right now there are enough LNG applications alone to eat up all of the additional natural gas supplies from the past 5 years. Not all of those will get built, but there are lots of other demand drivers.

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          • By Philip Lewis on August 23, 2014 at 12:16 pm

            My experience is that markets discount anything further than 12 months out to nearly zero impact. Which is quite rational, really. And what the gas market sees now is skyrocketing production and a raft of LNG projects that will never be built. LNG demand is tepid, the Feds will only approve so many, and investors’ appetite is limited.

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  4. By Dave Runyon on August 22, 2014 at 5:08 pm

    Robert, what do you think of the Siluria Technologies process to convert natural gas to “gasoline”? http://www.sfgate.com/business/article/Natural-gas-to-1-gasoline-5701521.php?cmpid=twitter

    Interesting Aramco is a big investor. Working at scale is usually a challenge…

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    • By Robert Rapier on August 22, 2014 at 6:43 pm

      Someone wrote and asked me about this yesterday. As I told that person, I I worked on methane coupling a dozen years ago. Sounds great on the surface as so many ideas do, but it’s a very difficult reaction with low yields. Methane just doesn’t want to couple.

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    • By TimC on August 25, 2014 at 11:01 am

      Another player in the NG-to-gasoline space is Haldor-Topsoe. They recently introduced their “TIGAS” technology, which is similar to the methanol-to-gasoline (MTG) process, but converts syngas to gasoline directly, without requiring methanol as an intermediate. It would be interesting to see how Siluria’s technology compares to MTG and TIGAS in terms of production cost and LCA.

      http://www.topsoe.com/business_areas/~/media/PDF%20files/tigas/10198_TIGAS_brochure_low%20rez.ashx

      If the large price gap between liquid fuels (>$30/MMBTU) and NG (<$4/MMBTU) persists we will likely see more activity in this area.

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  5. By Tom G. on August 25, 2014 at 1:17 pm

    Robert:

    I keep reading about how we are behind in adding to our winter natural gas reserves. Do you have any insights into why this may be happening?

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    • By Robert Rapier on August 25, 2014 at 6:54 pm

      Tom, it actually goes back to last winter, which had the largest draw down on record. We simply started from a deep hole, but have been climbing out. At the end of winter, we were something like 50% below normal for this time of year. But a mild summer has allowed that inventory gap to be close to where we are now only 17% below normal for this time of year.

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