(Forbes) – Much has been written about the Marcellus shales, the largest shale gas field in the US. The rapid drilling program has been responsible for a supply glut, which drove spot prices down this year as low as $2.00 per mmBtu. Since then, prices have recovered somewhat, to the $3.75 range. Until recently, it has been hard to get a good view of the supply side dynamics. This is largely because the shale phenomenon is so new that things have taken a while to sort out and for equilibriums to become established. We are now beginning to get a clearer picture.
In the near term, production figures will continue to rise, even as rig counts start to fall. Bentek, an analyst focusing in this area, predicts that Marcellus production will increase by 78% by 2015. The main reason for the increased production is simple: more than 1000 wills drilled over the past year and half have not yet been brought on line. That’s almost a third of the 2,879 wells currently completed in PA.
This overproduction is largely caused by a use-it-or-lose-it leasing dynamic which requires drillers to be actively producing hydrocarbons in order to extend leases. As a consequence, drillers continued to punch holes in the ground even as the oversupply situation became clear. But short-term and long-term market dynamics are two very different things. The immediate land leasing rush is over, and producers are already responding to market prices and moving rigs south and west to the more lucrative oil shales in Louisiana, Texas, Ohio, and elsewhere. In fact, the Baker Hughes rig count for PA dropped from 111 last October to just 63 this past month – the lowest number of rigs in three years. To put that in some perspective, though, the rigs can do much more in a shorter time than just a few years ago, as learning curves come down and productivity increases.
To get a clear picture as to what exactly drives the shift away from Pennsylvania, it is instructive to read the Q3 transcripts from some of the major drilling companies. Chesapeake’s transcript is perhaps the most interesting. They have been the largest driller for years, and they have a very explicit strategy in terms of rig deployment, production, and prices. They are also very bullish on the forecast for gas. CEO Aubrey McLendon notes “much to the amazement of most observers, the market has overcome an almost 900 bcf storage surplus from just seven months ago to a year-over-year storage surplus today of just about 120 bcf. We believe the small remaining storage overhang should soon go into a year-over-year deficit…Natural gas demand is growing across all sectors of consumption…we now expect to enjoy a multi-year rebound in natural gas prices driven by demand growth that is likely to be equally relentless.”
Chesapeake is putting its money where its mouth is, remaining largely unhedged for 2013. That is, they haven’t locked in any futures prices for gas, expecting the decline in gas production to push prices up. They forecast that just the decrease in number of their own rigs – from a high of 81 shale gas rigs to 5 in the Marcellus and 4 in other shale plays – will help move the market. As McLendon observes “today’s (forward price) strip for 2013 and frankly, for years beyond that, does not reflect a full appreciation of what happens when big producers like us reverse course and go in to managed decline…we’ll be down 7% year-over-year…Chesapeake has been responsible for about 30% of all the gas production growth the whole industry has generated in the past five years. And so, when we roll over, we think we will pull the whole market with us and we think that the prices that we see out in 2013 do not reflect that.”
Where are these rigs going instead? Into shale oils and gas liquids, where the money is. Chesapeake has already moved 72 rigs to the Eagle Ford, Anadarko, and Utica basins in search of more profitable oil and liquids. A re-direction of rigs back to gas country would come from either a decline in the price of oil, an increase in gas prices, or both. Chesapeake indicates that at $4-5 per MMbtu, they will stick with their current oil shale focus, but at $5-6 “The Marcellus is certainly competitive with oil projects.” That might also be true for the Haynesville and Barnett shales, though Chesapeake noted that the same use it or lose it leasing dynamic that kept rigs stuck in the gas plays would now apply to oil. One must drill the one or two year shale oil options and produce in order to convert them to open-ended arrangements.
One of the other larger operators, Cabot Oil and Gas appears to be slightly bucking the trend, ramping up from 4 rigs to 5 and able to generate a slightly positive cash flow at $3.50 (the price is about 10% north of that at present, from a low of around $2.00 in March of this year). However, they appear to be the anomaly.
Like Chesapeake, Range Resources is reducing its number of rigs in the northeast gas-rich portion of Marcellus next year, from 4 rigs to 1, with a refocus of capital on liquids-rich (ethane and propane) and oil projects. CEO, Jeffrey Ventura affirms that it’s not just about the economics of gas production. It’s really all about opportunity cost for rigs and development capital. “at $3 flat gas, it’s a 21% rate of return; at a $4 flat price, it’s 56%; at $5, it’s over 100%. So, it’s really price sensitive…we’ve got a really big bucket of dry gas opportunities, wet and super-rich opportunities and oil opportunities, and we have the operational flexibility to sort of throttle back and forth between those various buckets. And we’re looking at maximizing the returns for the dollars we spent, most efficiently drive enough cash flow per share, production per share, reserves per share.” For now, it’s about opportunity cost. And you can make a lot more money with $90 oil than with today’s $3.75 gas.
So, for now, drillers are generally going to prove up reserves and sit on them until the price of gas relative to oil makes it profitable to produce. As McLendon states “right now, we have one of the biggest gas storage reservoirs in the world sitting there in the Haynesville and sitting there in the Barnett and sitting there in the Marcellus. And it has incredible option value and I think what you’ll see is the demand for gas increase over the next one to five years to get to a point where the gas curve is going to have to go be competitive with the oil curve for projects for additional drilling in these fields. And when the gas curve pays us to take on those responsibilities of drilling those additional wells, we’ll do so. But not until then.” (emphasis added)
On the demand side, LNG exports are set to boom in coming years (requested permits are equivalent to more than 60% of current consumption). The demand for gas in power gen is increasing (coal to gas switching has been significant, and most new fossil power plants will be gas-fired). Transportation (use of LNG for long haul trucking driven by Clean Energy‘s natural gas highway plan) is seen as pushing up future demand for gas as well. And don’t forget the potential for rising industrial use where gas is utilized as a raw material feedstock.
As long as oil stays close to $90 per barrel, it appears likely that the gas supply will continue to throttle back, and the supply overhang will continue to dwindle. In the meantime, demand is likely to grow in a variety of sectors, prices will rise, and a longer-term price equilibrium will eventually kick into place. Gas at $5 to $6 per mmBtu may well be in our foreseeable future.