Thursday, June 4, 2009

A Long Recovery for Natural Gas Price: revisiting the Haynesville Shale

Natural gas prices increased 39% from a 6 1/2 -year low of $3.19/MMBtu on April 27 to $4.42 on May 13, 2009. Some think that the worst of the price collapse that began in July 2008 is over, and that gas prices will return to normal. I do not believe that is the case, though I certainly hope that I am wrong. Chesapeake Energy proclaimed in a recent investor presentation that “the fix is under way”, and that natural gas prices will soon return to $7-8/Mcf. Chesapeake and other companies make the case that prices will rebound because of the drastic decrease in drilling. The gas-directed rig count has fallen from 1,606 to 728 since September 2008 and, because about 1,100 rigs are needed to maintain supply, we are creating a deficit that should cause the price to rise.

The argument is logical and may prove true in the long term, but it is difficult to support based on current events. During the same two-and-a-half week period of rising prices, working gas in storage has been well above the five-year average (23% above the 2004-2008 average), indicating that supply is strong (Figure 1). While proponents of increased gas price may find some support in short-term price fluctuations that are based on sentiment, gas storage is what drives traders, and traders determine price. In other words, until storage levels decrease to 5-year averages or lower, I doubt that there can be any sustained gas-price increase. The recent rally is probably related to rising crude oil price, a weaker US dollar, and short-selling of gas futures contracts rather than a change in market fundamentals. At this writing, gas prices have already lost most of their recent gain.

US gas supply includes two external sources: pipeline imports from Canada and LNG cargoes from all over the world. Imports from Canada are down, but LNG deliveries are way up. April LNG imports averaged 2 Bcfd, compared to half that amount in March, according to Jeffries & Company (1). Pritchard Capital Partners expects LNG deliveries to average 3.5 Bcfd for 2009, and to be as high as 5 Bcfd (1). Global liquefaction capacity has increased more than 5 Bcfd this year as several large projects came on line. Also, LNG price has decreased due to lower global demand, reduced tanker costs, and because contract prices are tied to a trailing index of crude oil and other commodity prices that have fallen.

Oversupply of gas may continue for longer than some expect. Average US gas production increased from about 62 Bcfd during the first half of 2007 to almost 65 Bcfd in the second half of 2008 (Figure 2). In addition, there are large volumes of gas available from wells that are not yet connected to sales because of limited pipeline capacity and low netback cost. The Rocky Mountain Express Pipeline will open considerable volumes of gas that have not been previously available (3.2 Bcfd by June 2009, and an additional 1.8 Bcfd in November), and the Mid-Continent Express Pipeline recently added 0.64 Bcfd of capacity. Also, in the Gulf of Mexico Independence Hub, Thunderhorse and Tahiti platforms, as well as initial production at Perdido, will increase gas production in 2009-2010.

Reduced demand because of the global economic crisis may contribute to a prolonged slump. Demand in February 2009 fell 14.5 Bcfd (16%) compared to January, and 7.4 Bcfd (9%) compared to February 2008. In Februrary, all sectors of gas usage fell.

While the gas-directed rig count is down, drilling activity is strong in the Haynesville Shale play, where high-volume initial production rates work at cross-purposes to offset the over-supply of gas. There are at least 75 horizontal wells that are currently drilling, completing, or shut-in pending pipeline connection. This could increase Haynesville daily production to more than 300 MMcfd.

I want to thank readers and operators for their willingness to share information with me in response to my earlier column on the Haynesville Shale (World Oil, April 2009). There is no doubt that the Haynesville is different from other shale plays, mainly because it is overpressured (~0.85 psi/ft). Overpressure and corresponding microfracturing combined with high shale porosity result in average initial production rates of more than 12 MMcfd and per-well EURs as high as 9.0 Bcf.

I now think that the Haynesville Shale reserve estimates that I presented previously were too low. I have evaluated 43 horizontally drilled wells with some production history, and 14 wells with initial production rates only (Figures 3a and 3b). The most-likely average EUR for all operators is 3.6 Bcf per well within a probabilistic range of 2.8-3.6-4.4 Bcf/well (RBC Capital is more pessimistic, projecting an average 2.5 Bcf EUR for all horizontal wells (2). The average EUR for key operators in the play varies: Petrohawk Energy Corporation has higher average EURs (3.9-5.1-6.2 Bcf) while Chesapeake Energy Corporation’s EURs are lower (2.2-2.8-3.3 Bcf). The average for other operators is 2.8-3.7-4.5 Bcf/well.

I have not changed my conclusion that the Haynesville Shale play is marginally commercial. Drilling and completion costs vary from $7.5 to $10.5 million per well. The marginal cost for operators to find and develop natural gas reserves is $7 to 8/Mcf, and current netback prices in the play are less than $3/Mcf. The threshold netback gas price for a better-than-average 5.5 Bcf well to break even is $7/Mcf at NPV10 (Bodell and Pittinger, in press). For companies that have favorable hedge positions, realized gas prices for 2009 will be as high as $6.50/Mcf and $6.00/Mcf for 2010. This means that the play is marginally commercial today for operators with favorable hedge positions, but not commercial based on cost and price fundamentals.

While many believe that natural gas prices will increase to $7-$8/Mcf by the end of this year, I am more pessimistic. Increased LNG imports and strong current gas supply, expanded pipeline capacity and ongoing gas-directed drilling contribute to strong gas supply, while the recession is reducing demand. This leads me to conclude that prices may not increase until the second quarter of 2010. I am also skeptical that price will recover beyond approximately $5.50/Mcf, the average inflation-adjusted gas price since 1995 (Figure 4). Shale plays have increased the marginal cost of production by approximately $2/Mcf, and I doubt that the market will reward that inefficiency. It seems more likely that LNG and conventional gas will play an increasingly important role in US gas supply in the future because of cost.

(1) Platt’s Inside FERC’s Gas Market Report, May 1, 2009

(2) RBC Capital Markets, Weekly Haynesville Shale Report: May 13, 2009