Trouble Ahead

Jim Brown
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I am sure you have heard the saying that you can put a frog in a pot of cold water and then turn up the heat and the frog will die rather than jump out as the water warms. The change is so subtle that the frog does not realize he is in trouble.

Whether that saying is true or not is immaterial just as long as everyone understands the premise. Some change occurs so slowly that it remains out of the headlines until the disaster point is reached. It suddenly becomes a problem but one that takes a long time to fix.

The looming disaster is a shortage of natural gas. It will not happen over the next couple of years but we are going to face the problem soon. Currently there is a glut of natural gas because of the tens of thousands of shale wells that were drilled. Gas is produced alongside the oil as a byproduct. Nearly every shale well has significant gas production and a few are primarily gas and natural gas liquids.

Because of the glut of natural gas the price for gas has declined to $2.67 per Mcf. That is down from $4.50 in 2014 and a high of $13 in 2008. Gas is so cheap that very few producers are spending the money to drill for gas. Last week active gas rigs declined -9 to 202 and a new 18-year low.

That is not the entire story. Since gas is produced along with shale oil the -55% drop in active oil rigs has caused a 50% drop in the number of shale wells being drilled. Before Baker Hughes quit publishing quarterly well counts a couple of quarters ago we were drilling about 10,000 new wells per quarter. That means today we are only drilling about 5,000 so that equates to a loss of 5,000 wells that would have been producing some amount of natural gas.

Prior to the oil crash, gas production growth was accelerating by roughly 10% per month. The tall column on the right side of the chart was +12.5% growth in December 2014. Note how the growth rate has declined to just over 5% in June, the last column on the chart. That decline in production growth is not likely to change. Shale gas production growth in June was actually flat. The growth shown on the chart came from the Woodford shale with a 400 Mcf/d increase.

The other shale areas produced significantly less. The Marcellus, the biggest active gas field in the U.S., only increased 1.1 Mncf/d and the Utica +1.5 Mmcf/d. The Barnett, Fayetteville and Haynesville fields were down -25%, -14% and -48% from their peak production levels. That equates to a decline of -4.8 Bcf/d since 2012. Dry gas production declined -144 Mmcf/d in June. Dry gas production is flat to slightly declining. Without an increase in shale production we are headed for trouble. Note in the EIA chart below that every major field has either flattened or declined in 2015.

At the same time gas used for electricity production accounted for 32% compared to coal at 30%. That is the first time gas usage exceeded coal. With the government regulations shutting down coal plants at the fastest pace ever the demand for gas will only increase.

As if those numbers were not bad enough we have a gas guzzling monster headed for our shores. That is LNG exports. The first exports will begin in December from the Cheniere Energy plant in Louisiana. At first it will be a trickle but with nearly 25 liquefaction trains either planned or under construction the export demand could reach 10% of U.S. production by 2020.

Dry gas production for last week increased by only 0.4% to 72.3 Bcf/d. Injections into storage to cover the high winter heating demand have been averaging about 60 Bcf per week. Because winter demand is higher we need to go into the winter period with about 4,000 Bcf in storage. In 2013 we finished the winter with about 890 Bcf in storage. If we deduct 10% of production or roughly 7.2 Bcf per day we will have a shortfall during the summer months when injections into winter storage should occur. With the average injection today at about 60 Bcf per week and LNG exports on target to be more than 50 Bcf per week by 2020 there will not be enough gas to fill the winter storage.

The chart below shows the demand patterns for the last 365 days. The brown line is daily production and the blue line daily demand. We consume significantly more gas in the winter than productions and pipelines can deliver. That is why we try to put 4,000 Bcf into storage.

There is an answer to the problem. It is called supply and demand. Once gas supplies begin to run short, the price will rise significantly and producers will ramp up drilling for gas once again. However, that includes a "gotcha" for U.S. consumers. Long term gas prices are going a lot higher as a result of the LNG exports. Demand produces higher prices, which eventually creates more production but the cycle is in years not months.

We cannot just suddenly decide $5 gas is going to continue higher and see producers rush 500 rigs into the gas fields. That is especially true after the recent oil crash. Producers are going to be a lot more cautious about putting gas rigs back to work and that means gas prices will be higher for a long time, if not forever. In 2007 it was thought that gas production had peaked in North America and was headed for permanent decline. Shale oil drilling reversed that decline but it is only temporary. The EIA expects shale oil production to peak in 2017 as all the prime locations are completely drilled. As I showed above, a slowing number of shale wells mean slowing gas production.

U.S. consumers are going to be like that frog in a pan of slowly warming water. Home heating bills are going to creep up for the next five years until suddenly there will be an outrage at the high prices and there will be nothing we can do about it. Just like gasoline prices rocket higher but gently decline and never to the earlier lows, natural gas prices are set to rocket higher in the years to come and never return to the levels we pay today.

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Active Rigs

Active drilling rigs declined -8 to 877 for the week ended on Friday. Oil rigs rose another +1 for the week to 675. Active gas rigs dropped -9 to 202 and a new 18-year low. Active rigs have now declined -1,046 since the high of 1,931 in September. That is a -58% drop. Active offshore rigs fell another -2 to 30 and down -36 from year ago levels.

Oil Inventories

Crude inventories fell -5.5 million barrels to 450.8 million.

Refinery utilization declined from 95.1% to 94.5%.

U.S. production declined -11,000 barrels to 9.337 mbpd, down from the 9.61 mbpd and 40-year high in June. Demand fell -117,000 bpd.

Cushing inventories rose slightly to 57.7 million.

Gasoline inventories rose +1.7 million barrels to 214.4 million. Gasoline demand fell -556,000 bpd.

Distillate inventories rose +1.4 million barrels to 149.8 million and a three-month high. Demand fell -294,000 bpd.

In the graphic below green represents a recent high and yellow a recent low.