Does Natural Gas History = $10 A Barrel Oil In Our Future?

The news is full of claims and predictions about where crude oil prices are headed, and how soon they will get there. Remember the admonition to economists: forecast often but only give a price with no date, or a date with no price. As oil prices have rebounded during the past two weeks, we continue to see forecasts claiming the U.S. is headed for oil prices somewhere between $20 and $10 a barrel. The analysis behind these forecasts relies on the recent history of domestic natural gas production as the precursor for future oil production. These forecasters rely on a single chart showing U.S. natural gas output and the number of rigs drilling gas wells.

Their charts, similar to Exhibit 1, show how the gas rig count began climbing in the early 1990s following the decontrol of natural gas prices. Gas drilling peaked in the late 1990s just prior to the 1997-1998 recession and its corresponding drop in gas demand. Drilling rebounded in 1999 and climbed steadily through 2001 up to the next recession, which followed the horrific events of 9/11. From that point forward, shrinking domestic gas supplies and rising demand propelled gas prices to double digits, rejuvenating gas drilling. It was at this time that the success of marrying horizontal drilling and hydraulic fracturing emerged as a way to tap the prolific gas supplies trapped in shale formations that underlays almost every oil and gas producing basin in the nation. The initial flows from shale wells are huge, although they are accompanied by rapid production declines. The magic of being able to tap these shale formations generated optimism that the country was on the cusp of a dramatic shift in the fortunes of the domestic gas business. The American Shale Revolution was born of this belief about a paradigm shift for both the physical and economic outlooks for natural gas.

To better understand the shale gas boom and its subsequent bust, consider the chart in Exhibit 2. In order to plot the gas price per thousand cubic feet (Mcf) on the same scale as the number of gas-directed drilling rigs, we multiplied the Mcf price by 100. Thus, a natural gas price of $6/Mcf became 600 on the right-hand scale. The lure of huge gas flows coupled with high gas prices in 2004-2008 provided the incentives for producers to rush to lease up all the potential gas shale acreage in the United States, and launch the drilling boom. This was a drilling boom such as the industry had not been experienced since the late 1970’s. When you examine the data within the circle labeled A on the chart, you see that other than for the two price spikes to double digit gas prices, they generally traded in a $6 - $7/Mcf range, substantially higher than any time in the previous 16 years. Prospects of these high gas prices being sustained drove the number of active gas rigs to march higher with the byproduct being that the nearly decade-long natural gas output decline was arrested and production soon began growing.

By the summer of 2008 the extent of the financial crisis became evident. It eventually exploded into a full panic by that fall as several prominent investment banks failed, questions were raised about the health of the world’s financial system and governments mounted full-scale rescues of their financial institutions. The financial panic was essentially a global liquidity crisis that forced individuals and companies to operate as if the entire world’s financial system would fail, making liquidity the primary operating rule. Energy demand fell, commodity prices, including crude oil and natural gas, collapsed and drilling and completing wells ceased as oil and gas producers conserved cash in order to sustain their financial and liquidity positions. As natural gas prices dropped by more than a third, or into the $3-$4/Mcf level, high-cost gas shale plays proved uneconomic forcing producers to revise their corporate strategies. About that time, some producers disclosed successes they had by drilling horizontal wells in oil shale formations and successfully fracking them with similar results as gas shale wells – high initial production flows but rapid decline rates. With global crude oil prices rebounding from the $30’s a barrel toward the $70’s, producers shifted their focus from gas to oil shales and tight oil formations. A new American shale revolution was launched. The data reflecting the gas shale bust is shown within the circle labeled B on the chart.

Seizing on this gas shale boom-to-bust history, the low-oil price forecasters point out that after the gas rig count peaked in 2008, natural gas production growth continued unabated. Forecasters made the leap to predicting a similar scenario for crude oil output. They contend that the gas output growth with fewer gas rigs working demonstrates the success of horizontal drilling and hydraulic fracturing technology, which they contend will also drive future oil shale and tight oil production. According to these forecasters, we are doomed to a scenario of continued oil output growth that overwhelms our demand needs and condemns us with low oil prices for years to come. But is this truly a case of Mark Twain’s “history doesn’t repeat but it does rhyme a lot” claim coming true?

We decided to examine the evolution of natural gas production and whether there were factors that explained its growth in the face of a falling rig count that may not exist in the oil arena. A key difference, in our view, is that the natural gas play shifted from dry gas to wet gas and gas associated with oil plays. In effect, natural gas had more resource options to exploit that have largely driven the continued gas output growth, whereas, in our view, crude oil lacks alternative resources to exploit. To test this theory we looked at gross natural gas withdrawals from wells against growth in the production of natural gas liquids (NGLs) from field plants, i.e., the installations in gas fields that strip out the heavier liquids in a natural gas stream. We believe this growth would reflect the shift in drilling from dry gas wells in favor of wet gas plays. The chart in Exhibit 3 shows this relationship. We marked the point in time when the number of natural gas-focused drilling rigs peaked in late 2008, because rigs drilling wet gas plays are classified as oil rigs.

We believe there are three important observations to be drawn from this chart. First, natural gas output was already rising when the natural gas rig count peaked. This suggests that dry gas production would continue to grow as dry gas wells were completed and brought into production. Second, NGL output began rising almost immediately after the gas rig count peaked and the oil rig count began rising. Third, the slope of the increase in NGL output has steepened in the past 18 months as the oil rig count climbed to its recent peak, driven by extraordinarily high oil prices that have boosted the price of NGLs. Demand for NGLs has also increased as America’s petrochemical industry demand has grown and more NGLs are being exported. This chart confirms part of our thesis as to why gas output has continued to grow despite the fall in gas rigs and continued low natural gas prices.

Left unanswered is the question of how much of the current natural gas output is associated with crude oil production. The Energy Information Administration (EIA) publishes estimates of monthly gross natural gas withdrawals from wells. That data has been published since 1980, and in more recent years the EIA has disassembled that flow. Starting in January 1991, the agency identified the amount of gas flowing from gas and oil wells. In 2003, the EIA started publishing natural gas volumes flowing from coalbed wells and in 2007, the flow from gas shale wells. Because this detail is published with a lag, 2014’s monthly data has yet to be released.

Utilizing this data (Exhibit 4, next page), we were surprised to see that the volume of gas from oil wells has been essentially flat since 1993 with what appears to be seasonal ups and downs. In 2012 and 2013, it appears the flow of gas from oil wells has actually fallen slightly. When this volume is expressed as a percentage of total gas withdrawals, we see a dramatic decline in that ratio since the gas shale boom commenced in 2005, characterized by the beginning of the surge in total gas output. For reference, we plotted the volume of gas attributed to gas shale wells in addition to the date when the natural gas rig count peaked.

One of the telling developments with respect to the possibility for continued growth of both natural gas and crude oil is the impact of pricing in the liquids markets. In Exhibit 5, we have plotted natural gas spot prices, the value of a barrel of NGLs and the refiner acquisition cost for domestic crude oil. The NGL price is a composite price per million British thermal units (Btu) based on daily spot prices as reported by Bloomberg for these products at the main trading hub of Mont Belvieu, Texas. We have converted the EIA estimate to a per-barrel-value based on the ratio that a barrel of NGLs contains 4.2 million Btus of energy as reported by www.physics.uci.edu. The data shows that although NGLs are derived from natural gas, their high value as substitutes for crude oil-derived products means they trade more in-line with oil price movements than natural gas prices. That can be seen quite clearly in 2012 and 2013 rebounded but crude oil and NGL prices remained steady.

For some reason the EIA has not posted a monthly average price for NGLs for December and January, although they have posted prices for natural gas and crude oil. We see that the October and November NGL price was reflecting a lower value in-line with the oil price decline. An early January article in Wall Street Daily states that between September 1 and mid-December 2014, NGL prices fell by at least 40%. If so, that means the December 2014 NGL price should be somewhere in the mid $20’s a barrel, reflecting the further decline in crude oil prices.

We note that NGL pricing during 2009-2014 was much closer to the oil price in the early years, with the spread widening beginning in the second half of 2011 and continuing until very recently. The easiest explanation for the widened price spread is the boom in NGL output observed in Exhibit 5. Again, as pointed out in the Wall Street Daily article, NGL production is above three million barrels per day, a 60% increase over the past decade. Both ethane and propane are now above one million barrels per day, due to strong pricing. The recent rapid decline in the crude oil price, as well as in the price of natural gas, is contributing to the narrowing of the spread between crude oil and NGL prices. If natural gas prices were to increase in response to the colder winter weather, some NGL production might not be stripped from the gas stream as some gas contracts pay the producer based on the heat content of the natural gas delivered, which is higher when the NGLs are left in the flow than without them.

Our conclusion is that the continued growth in natural gas output has largely been due to the rise in crude oil prices that have contributed to a dramatic increase in NGL output, which has encouraged producers to seek out those shale formations where liquid (NGL) content is the greatest. The incentive to continue drilling for NGL-rich natural gas may ease with sustained lower crude oil prices. On the other hand, mitigating that outlook is the possibility of higher NGL prices as a result of the startup of the new and expanded petrochemical plants coming on stream during 2015-2018.

The NGL factor has been an important driver for natural gas production growth. However, there is no equivalent secondary driver for crude oil production. Future crude oil production growth will depend on new well drilling and the productivity of those new wells, as well as the production performance of recently drilled and completed oil wells. All of that production will be measured against oil prices and if found profitable will continue. If uneconomic, it will stop. New and improved drilling and completion technology mayimprove future well output, but it is impossible to forecast those developments. The record shows that initial well output has increased over time, and decline rates have become slightly less steep. That means new wells are producing greater oil volumes in the first four years of existence.

What we don’t know yet is whether the ultimate recoverability of oil from these wells has increased or are we merely producing the same reserves at a faster pace? These are important questions, for which there are no answers, only thoughts and guesses. Are those variables at a peak such that future well performance will not improve, or might it even decline, especially as we drill up the sweet spots in the shale formations? Or maybe technology will allow us to recover significantly more from these shale formations, as we know current recovery represents only a small percentage. Short of positive developments in response to these issues, there is no other source of oil production growth on the horizon short of producers significantly reducing their breakeven well costs. This explains the quick cost-cutting response of oil and gas companies and the intense pressure being leveled at the oilfield service companies. Based on current conditions, we do not believe you can assume that oil production will grow for years following a peak in the oil rig count as has happened with natural gas because there is no alternative for producing more oil than drilling more wells.

For some reason the EIA has not posted a monthly average price for NGLs for December and January, although they have posted prices for natural gas and crude oil. We see that the October and November NGL price was reflecting a lower value in-line with the oil price decline. An early January article in Wall Street Daily states that between September 1 and mid-December 2014, NGL prices fell by at least 40%. If so, that means the December 2014 NGL price should be somewhere in the mid $20’s a barrel, reflecting the further decline in crude oil prices.

We note that NGL pricing during 2009-2014 was much closer to the oil price in the early years, with the spread widening beginning in the second half of 2011 and continuing until very recently. The easiest explanation for the widened price spread is the boom in NGL output observed in Exhibit 5. Again, as pointed out in the Wall Street Daily article, NGL production is above three million barrels per day, a 60% increase over the past decade. Both ethane and propane are now above one million barrels per day, due to strong pricing. The recent rapid decline in the crude oil price, as well as in the price of natural gas, is contributing to the narrowing of the spread between crude oil and NGL prices. If natural gas prices were to increase in response to the colder winter weather, some NGL production might not be stripped from the gas stream as some gas contracts pay the producer based on the heat content of the natural gas delivered, which is higher when the NGLs are left in the flow than without them.

Our conclusion is that the continued growth in natural gas output has largely been due to the rise in crude oil prices that have contributed to a dramatic increase in NGL output, which has encouraged producers to seek out those shale formations where liquid (NGL) content is the greatest. The incentive to continue drilling for NGL-rich natural gas may ease with sustained lower crude oil prices. On the other hand, mitigating that outlook is the possibility of higher NGL prices as a result of the startup of the new and expanded petrochemical plants coming on stream during 2015-2018.

The NGL factor has been an important driver for natural gas production growth. However, there is no equivalent secondary driver for crude oil production. Future crude oil production growth will depend on new well drilling and the productivity of those new wells, as well as the production performance of recently drilled and completed oil wells. All of that production will be measured against oil prices and if found profitable will continue. If uneconomic, it will stop. New and improved drilling and completion technology mayimprove future well output, but it is impossible to forecast those developments. The record shows that initial well output has increased over time, and decline rates have become slightly less steep. That means new wells are producing greater oil volumes in the first four years of existence.

What we don’t know yet is whether the ultimate recoverability of oil from these wells has increased or are we merely producing the same reserves at a faster pace? These are important questions, for which there are no answers, only thoughts and guesses. Are those variables at a peak such that future well performance will not improve, or might it even decline, especially as we drill up the sweet spots in the shale formations? Or maybe technology will allow us to recover significantly more from these shale formations, as we know current recovery represents only a small percentage. Short of positive developments in response to these issues, there is no other source of oil production growth on the horizon short of producers significantly reducing their breakeven well costs. This explains the quick cost-cutting response of oil and gas companies and the intense pressure being leveled at the oilfield service companies. Based on current conditions, we do not believe you can assume that oil production will grow for years following a peak in the oil rig count as has happened with natural gas because there is no alternative for producing more oil than drilling more wells.