Gas Suffocating Energy Stocks

Jim Brown
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The bloated inventory in natural gas is pushing all energy stocks lower as gas prices hit new ten year lows.

Nothing has changed since last week's commentary other than gas prices fell again and energy equities followed suit. Baker Hughes reported a drop in the U.S. rig count of -16 to 1,968 for the fifth decrease in eight weeks. The natural gas rig count fell for the eleventh week with a drop of -11 rigs to a total of 652. This is the lowest level since May 3rd, 2002 and -30% off the 2011 peak of 936 set in October. That compares to the all time high of 1,606 set in the summer of 2008 when the shale gas boom was at its peak.

Oil rigs hit a 25-year high the prior week at 1,317 but fell -4 last week. That is still well above the year ago level at 851 and the low of 179 in June 2009.

This will eventually help slow the supply of natural gas but it could be a year or more before we see any material impact. Leases currently being drilled in order to anchor the lease with production will continue. There are between 3,000 and 4,000 wells that have been drilled but not completed. Once gas prices begin to firm those will be completed before new wells are drilled. Companies like Chesapeake (CHK) have curtailed production to slow down supply. When prices begin to firm those curtailments will be lifted. Lastly those companies drilling in the liquid rich plays in order to produce oil and natural gas liquids will still be producing the associated gas that comes with each well.

Occidental (OXY) is primarily focused on oil but 30% of its production is natural gas because the gas is produced with the oil. Companies drilling in the NGL rich shales can still see 70% of their production as gas.

There is no quick fix for the gas glut. Industry and electrical generation companies are moving to expand their use of natural gas but the process is slow and scattered. There is no tsunami of change that is going to overwhelm supplies in the next 24 months.

Gas in storage is currently 2.437 Tcf. The record is 3.852 Tcf and maximum storage capacity is 4.577 Tcf. The EIA inventory report last week showed an injection of 57 Bcf. At that rate of roughly 250 Bcf per month or more the available storage capacity will be maxed out well before the November 1st date where winter draws typically begin. The offset would be an unusually hot summer where abnormally high amounts of gas are withdrawn to supply electricity for cooling. With winter the fourth warmest on record the odds of a hot summer are very good. In Denver we are already seeing temperatures in the mid 80s and that is very rare for this time of year.

Gas in storage is 58% above the five year average. Gas prices reflect this and the fear of a future glut closing down pipelines. As supplies backup the pressure in the pipelines increase and low volume producers can be shutout from producing at full capacity because of pressures. This pushes prices lower as competition for pipeline space intensifies.

Gas futures declined to $2.12 on Friday. Prices are approaching the levels where some producers will be selling it below their cost of production. They will be faced with selling for a loss or curtailing production. Unfortunately many of those costs are related to drilling the well and are fixed by the time production begins.

Natural Gas Chart

There is no easy answer to the gas glut other than time. As time passes the demand for gas will increase and the current glut will ease. Since most gas wells deplete about 75% in their first two years of operation the current boom in production will fade 12-18 months from now. From that point producers will be faced with a decision on how rapidly they want to step up drilling in order to avoid a resumption of the problem.

The eventual solution for the gas glut will be an increase in industrial usage and increase in gas fired power plants. Adding gas fueled vehicles to the U.S. fleet will help but the time needed to build fueling stations and build up an inventory of vehicles will be in years not months. The biggest help for the glut would be the completion of LNG export facilities. There are several under construction and 45 permits for LNG facilities. Gas in Asia sells for $12 to $16 per mcf. Europe would also love to have more LNG imports to reduce their dependency on Russia. There is plenty of incentive to export LNG but the process is very expensive and time consuming to setup and nobody wants an LNG facility in their backyard. This will happen and it will help relieve the glut.

However, exporting LNG will raise gas prices for consumers. The EIA said in January that exporting LNG could hike consumer prices by as much as 54%. The EIA said daily exports of 6 Bcf would hike prices by 14% and 12 Bcf by 36%. Prices at the wellhead would rise by more than 50% by 2018.

Cheniere Energy (LNG) is quickly moving forward to construct four LNG trains for export at the Sabine Pass Liquefaction Project. They have arranged financing to construct four trains with expected capacity of 4.5 MTPA each for a total of 18 MTPA. (MTPA = million tons per annum, 1 Bcf/day = 7.5 MTPA) Basically they will be able to export about 2.5 Bcf per day. Development of the first two trains cost roughly $5 billion with the second two trains expected to be slightly less. The first two trains are expected to begin operations in 2015/2016 and the second two in 2017/2018.

These terminals are extremely expensive and even if you built 10 of the Sabine Pass facilities around the country at a cost of $10 billion each you would only export 25 Bcf per day of gas by 2020. To put this into perspective 57 Bcf of excess gas was injected into storage last week.

Regulators are not going to let companies build that many plants. Despite having a glut today they don't want to allow us to export away our competitive advantage. Having cheap gas is already causing businesses to move manufacturing plants back from overseas. Businesses moved plants overseas back in 2004-2007 when our gas was so expensive. Now the tables have turned and we are the cheapest. Exporting it all away would ruin that competitive edge.

Because of the lead time to build LNG export terminals, build factories and power stations to take advantage of cheap gas and convert part of our transportation to natural gas, we can expect gas prices to remain relatively low through 2013 if not longer.

Schlumberger (SLB) warned last week that falling rig counts for natural gas were lowering profit margins on hydraulic fracturing services. They said the declining rates for gas well completions were not being offset by a similar uptick in oil well completions. Companies were drilling gas wells more rapidly than similar oil wells. Also, the shift of gas fracking rigs to oil plays increased the competition and lowered the prices for the service. Frack rig utilizations had declined and that increased the costs.

Nabors (NBR) is responding to the situation by announcing the sales of $800 million to $1 billion of non-core assets in an effort to streamline the business and eliminate costs.

The decline in the energy sector as a result of the gas glut has pushed energy equities to the most undervalued level since the 2008 credit crisis. If you take the S&P Energy Select Sector SPDR (XLE) as a broad representation of equity prices in the sector and compare it to Brent the ratio of 0.582 is the lowest since the 0.547 during the financial crisis. (XLE / Brent or $71.73 / $123.08 = 0.582) That suggests this is a buying opportunity for names primarily looking for and producing oil.

Oil prices are not likely to decline from here. President Obama waited until the end of his 90-day limit to certify the new sanctions for anyone buying or facilitating the purchase of Iranian oil. When the sanctions bill was initially signed the president had until March 31st to certify that partially cutting off Iranian oil exports would not cause a hardship on consumers.

This put Obama in a precarious position. For weeks now his administration along with the IEA, U.K. and France have been talking up a potential coordinated release of reserves to lower fuel prices. The IEA, Germany and Saudi Arabia all said repeatedly there was no shortage of oil. Saudi made a big deal about the 1.0 mbpd excess production in the market today and their ability to produce another 2.5 mbpd if needed. The president had to weigh the risk of higher consumer prices against the plan to force Iran to the negotiating table. I believe he made the right decision even though fuel prices will continue to rise with the price of oil. Syria, Nigeria, Sudan, Yemen, Libya, Columbia and Brazil are all experiencing production problems that are limiting supply. Iran's exports were down a reported -300,000 bpd in March and are now expected to decline to a loss of -1.0 mbpd by July, possibly more. In theory there is enough supply to compensate for the loss but prices will continue to tick higher towards Memorial Day.

Gasoline prices are averaging $3.925 and diesel $4.164 this weekend.

The rising price of oil has driven a surge in deepwater drilling. A little more than 15 years ago there were only 20 deepwater rigs. Today there are more than 200 and climbing rapidly. You would think that would be a glut but deepwater is the last major frontier for high production wells. You can't drill an onshore well today and get 25,000 bpd. You would consider it a very good well if you got 2,500 bpd. Several companies have reported in the last few weeks new production from wells with 35,000 to 75,000 bpd. That is truly black gold.

Morgan Stanley expects deepwater rig rental rates to climb +28% to $714,000 per day by the third quarter. That is up from an average of $560,000 per day currently. Analyst, Ole Sloree, called this move a "super spike." Transocean told investors at the Howard Weil Energy Conference on March 26th, "Our long term outlook for ultra-deepwater is very, very robust." Transocean just leased a deepwater rig for $650,000 with an increase to $695k on extensions. The record rate is $703,000 per day set last year. Morgan Stanley believes the rig rates will remain well above $600,000 through 2014. A $600 million drillship can be fully paid for with a five year contract.

National Oilwell is expected to supply 85% of the equipment for new offshore rigs according to Dahlman Rose and there are quite a few in the pipeline. Rowan has three ultradeep rigs under construction to deliver in 2013 and JP Morgan expects their initial lease rates to be $700,000 per day. Noble (NE) has five new rigs under construction for delivery in 2013-2014. Diamond Offshore has four rigs under construction.

We need to be patient because the long term fundamentals remain firmly positive. Remember, oil prices are still in the $105-$125 range and not $65-$75. The long term trend is still up.

Our biggest risk is that high gasoline prices will push the U.S. back into a recession. We will have to watch the economic numbers closely over the next 60-days to see if the trend is changing.

Jim Brown

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