Natural Gas Outlook

Jim Brown
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I have received several emails recently about natural gas demand and pricing. Is it time to buy natural gas companies? I wish I knew for sure. There is no easy answer to this question. Some like EOG are setting new multi-month highs. The basis for the new found hope is the small injections of gas into storage on a weekly basis. Last week only 20 Bcf was injected into storage. These small injection numbers suggest to some that production is declining and prices will be rising soon.

However, the total gas in storage is now 3,261 Bcf compared to 2,819 Bcf for the same week in 2011 and the five year average of 2,898 Bcf. There is significantly more gas in storage this year than in prior years. In the Moody's chart below you can easily see how the normal decline to the 1,700 Bcf range did not occur this year. The low was only about 2,400 Bcf in February and that means supplies going into the normal fall build cycle started from a level that was 700 Bcf higher than normal. At our current build rate of 25 Bcf per week that is the equivalent of 28 weeks of additional injections as a starting point.

Moody's Gas in Storage Chart

The theory pushing gas stocks higher is that the 25 Bcf injections are due to lower production. That may be true to some extent but a bigger factor is the heat wave currently engulfing most of the country. Heat and drought are not actually the same thing but in this case it has been true. We are seeing record temperatures all over the country and gas usage for electricity generation is very high. This is draining gas from storage and preventing new gas from reaching storage.

Hypothetically production of 300 Bcf minus demand of 225 Bcf would produce an injection of 75 Bcf into storage. The excessive heat this year has increased demand and prevented the normal injection into storage. A normal injection for this time of year is about 74 Bcf. In the chart below the red areas are the deviation from normal with the darker areas being the largest deviation. July 2012 was the hottest month on record according to the weather service. The EIA says the consumption of natural gas for power generation rose +14.4% in July over the same period in 2011. In the Midwest gas burn for electrical generation rose nearly 50%. In the Southeast it rose +25%. Gas used for electrical production in July averaged 35.06 Bcf per day. (245 Bcf per week)

Gas production was 2.4% higher last week than the same week in 2011.

The key factors in pricing are production and gas in storage. Our storage capacity is about 3,900 Bcf. Gas is injected into storage during the spring and fall months when demand is low to offset the high demand in the winter when demand is greater than our production capacity. When storage levels near capacity gas prices fall dramatically. In the Moody's chart above the upward boundary is maximum capacity not some function of production. When capacity is reached the pressure in pipelines increases and low pressure suppliers can no longer push gas into the pipelines. Prices decline as bidding for available storage heats up.

The production side has not changed. Production was 2.4% higher than 2011 levels and that is with thousands of wells in voluntary curtailment. Several thousand wells in the various shale plays have been drilled but not completed. More than 1,000 wells in the Barnett Shale are waiting for higher prices before they will be completed and hooked up to the pipeline system.

Everyone points to the decline in working rigs looking for natural gas as a reason to buy gas today. Gas rigs have declined to a 13 year low at 484 last week. This compares to the recent peak of 936 in October 2011. The all time high for gas rigs was 1,606 in August 2008.

Note that overall gas production has not declined in 2012 but continues to increase.

Gas drilling has declined significantly with more than 500 gas rigs moving into the search for oil and NGLs. However, that does not mean they are no longer producing natural gas. Those 500+ rigs searching for oil and NGLs will still produce a significant amount of natural gas as "associated" gas that is produced with the oil. Occidental reported a number recently claiming their new oil production included 35% natural gas. They are very active in the shale plays plus the Permian Basin.

Many rigs have moved to "liquids producing areas" where the majority of the revenue comes from NGLs but they are still producing gas along with those natural gas liquids.

Lastly, the majority of gas from a new well is produced in the first 12-18 months. Depletion rates from shale gas plays are extremely high and as many as 35% of new gas wells will never produce enough gas to recover the drilling costs. The initial production comes on strong but then dwindles by as much as 75% in the first year and 85% by the end of the second year.

This is a positive for investors looking for a spike in gas prices. It means that wells drilled over the last three years are well into their depletion phase and are producing at only a fraction of their original rate. However, with roughly 500 rigs drilling gas wells plus 1,432 rigs searching for oil and liquids, the highest since Baker Hughes began keeping records in 1987, there are still about 5,000 wells completed each month and the majority will produce gas in some form with the highest production in the earliest months.

The bottom line to this analysis is that gas production growth has slowed but it is still growing. Clearly the low gas prices have also increased demand but there is a lot of constrained production waiting for prices to rise.

The recent trend by companies like Apache, Chesapeake, Occidental, etc is to write down their natural gas assets because they don't foresee a material rise in gas prices in the near future.

We are three months away from the start of the winter gas demand. If the heat wave was to dissipate I believe we would see a significant increase in the amount of gas injected into storage. With 3,261 Bcf of gas in storage and a theoretical limit around 3,900 Bcf that means we can inject roughly 639 Bcf into storage before capacity is reached. At the normal injection rate of 75 Bcf per week after Labor Day that means we have nine weeks of available capacity. It also suggests that we will reach that capacity limit before heating season begins. That will force gas prices lower along with the prices of gas producing energy stocks.

Jim Brown

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