Is Natural Gas Cheap?

by David Galland - Managing Editor, BIG GOLD from Casey Research
At the height of its late 2005 rally, natural gas in the U.S. was selling for just over $16/MMBtu, 350% higher than today’s price of $3.56. The oil/gas ratio, now over 18, is an all-time high… suggesting that natural gas is dirt cheap. So, it’s a buy, right?
In a phrase, not exactly.
According to a recent report by Natural Gas Intelligence, U.S. natural gas available for production “has jumped 58% in the past four years, driven by improved drilling techniques and the discovery of huge shale fields in Texas, Louisiana, Arkansas and Pennsylvania, according to a report issued Thursday by the nonprofit Potential Gas Committee (PGC).”
According to the report, the increase in gas discoveries and production improvements means that North America shouldn’t have to be concerned about gas supplies for up to 100 years!
Dr. Marc Bustin provided an overview of the situation in the May edition of Casey Energy Opportunities.
In the United States, the tremendous growth in natural gas resources and estimated recoverable natural gas, particularly from gas shales, just in the last two years (Figure 1) is sending tremors through the entire industry. These tremors include the risk of making obsolete the proposed $26 billion Alaskan and $16 billion northern Canadian pipelines to tap northern gas resources and a slue of proposed LNG terminals... unless they are for export!
The numbers currently kicked around are that something around 2,000 trillion cubic feet of gas are technically recoverable in the United States. At current production rates, this supply would last about 90 years.
Some analysts are predicting that even if the U.S. economy recovers in the next year, the amount of gas discovered to date in gas shales will severely dampen any increase in gas price for some time. According to a new study by energy consulting firm CERA (Cambridge Energy Research Associates), new technologies for unconventional gas fields are being applied so successfully that supply is essentially no longer a driver in either production or price in the North American gas market – whatever the market wants, North American gas fields can supply. CERA reports that natural gas production in the Lower 48 states has risen a startling 14% from 2007 to 2008, for example.

Figure 1. Major shale areas or formations in the U.S. and the estimated recoverable natural gas in 2006 and 2008. Modified from Daily Oil Bulletin (May 4, 2009).
Given the increase in production and the small slide in demand, the price of natural gas has fallen to around $3.50-$4.00 per MMBtu (down from $13 per MMBtu last summer). At these prices, many gas prospects are uneconomic, and thus there has been a marked decline in the number of wells being drilled. Rig activity (how many rigs are operating) is down about 50% in North America.
But here is where an interesting feedback mechanism kicks in. One of the characteristics of unconventional shale gas wells, and to a lesser extent natural gas wells in general, is that the production rate declines through time. Most shale wells’ production rates decline 60 to 90% in the first year. If you were a gas company trying to survive amidst today's low prices, the rate of return on your capital investment would also be painfully low for a significant amount of gas if this were your initial year of production.
Another complementary fact is that over 50% of natural gas consumed in the United States today is from wells drilled less than three years ago, and 25-30% of the gas produced today comes from wells drilled last year (Figure 2).
Hence it follows that if there are 50% fewer wells drilled this year (from the drop in rig activity), new production will decline about 35-40% by the end of the year, so there will be gas shortages. Those will in turn lead to higher North American prices, which in turn should lead to additional drilling.


Figure 2. Historical gas production in the U.S. showing the percentage of production from vintage of well (modified from Chesapeake April 2009 Investor presentation from original data of HIS Energy)


Everything else being equal (which it's not, this being the real, not the mathematical world), gas prices and drilling will see-saw until an equilibrium is reached. In detail, of course, things are more complicated, but it is pretty clear that gas prices will have to rise within the year, and the big losers will remain the more expensive plays that require higher gas prices to be economic.
Where will the gas price end up in the short term? A poll of analysts by Reuters suggests $6 MMBtu in 2010 (Daily Oil Bulletin, May 4, 2009), but I don’t think I would bet on a gas price based on a vote by analysts. At the same time, it's an interesting coincidence (or not – coincidence, that is) that many prospects become economic at around the $6 MMBtu range. Among them are the Haynesville and Marcellus shales – and it's no large leap from there to see their tremendous gas production potential acting as a buffer to gas prices going much higher in the near term.
Thus, while there may be some seasonal and relatively short-term trading opportunities in natural gas, the overhang of ready supply places a fairly firm cap on the price. Which begs the question, which big-trend energy opportunities should be getting our attention today?
Marin Katusa, who heads the Casey Research energy team, answers the question by, correctly, cataloging the opportunities according to geography.
In North America 1. Geothermal -- the most interesting of the alternative energy sources, by a wide margin. 2. Nuclear. 3. Oil.
In Europe1. Unconventional gas has, by far, the most upside.2. Unconventional oil.3. Small hydro (such as run of river).
In Africa First and foremost, you want to avoid infrastructure plays (pipelines, refineries, etc). Then you want to look for areas with huge oil potential, which have been held off the market by concerns over political risk. I like what Lukas Lundin is doing in Ethiopia, Somalia, and Kenya, hunting for “elephants” with the idea of eventually selling the discoveries off to the Chinese.
In Asia,1. Liquid Natural Gas (LNG)2. Coal Bed Methane (CBM)
Lessons to Learn
There are a couple of useful lessons to be derived by investors looking to tap into the virtually unlimited opportunities in energy.
First, just because something is “cheap” doesn’t mean it can’t stay cheap, regardless of historical ratios -- if there has been a fundamental shift in the supply/demand equation. Which is very much the case with North American natural gas.
Secondly, geological and transport considerations make much of the energy complex a “local” market.
For example, while North America enjoys an abundance of natural gas, Europe is forced to rely on the heavy-handed Russians for the bulk of supplies. As you read this, there are companies looking to break the Russian grip by applying the same unconventional gas technologies that have so successfully built gas supplies in the U.S. -- technologies that are only just now being applied in Europe. Early investors could reap huge profits.In short, the real opportunities are not found by simply “investing in energy” but rather by taking the time to understand the structural differences within the energy complex and cherry picking the special situations that invariably exist in a sector this large.

Obama-nomics

Foreign Investment in the U.S. – Going Down, Down, Down

I've been watching the actions of foreign holders of U.S. dollars as closely as a Las Vegas pit boss watches a card player on a $1 million winning streak. Many of those in the deflation camp largely, or entirely, ignore the potential role these foreign holders may play in the drama now unfolding. But in fact, foreigners have, over the last decade, been by far the single most important source of buying for U.S. Treasuries.Given the Treasury’s need to flog on the order of $3 trillion worth of its unbacked paper this year just to keep the government’s doors open – and that is a four- or fivefold increase over 2008 – the foreign buyers not only have to show up for the Treasury auctions, they have to show up in droves.In mid-July, the Associated Press reported that “Foreign demand for long-term U.S. financial assets dropped by the largest amount in four months in May, as Japan and Russia trimmed their holdings of Treasury securities . . . foreigners actually sold $19.8 billion more long-term U.S. securities than they purchased in May. That compared with net purchases of $11.5 billion in April.”Below you see the big picture of all cross-border flows in May as published by the U.S. Treasury. It shows both foreign investment in the U.S. and U.S. investment abroad. It includes Treasuries, agencies, corporate bonds, equities, and short-term instruments like T-bills. Foreigners bought a lot of T-bills when the credit crisis became acute.
This should be a serious situation with a big drop in foreign investible funds for meeting U.S. borrowing needs. The borrowing by households and business has dropped close to zero, decreasing demand, while government borrowing has jumped but is still smaller than the private borrowing drop. The Fed has added some lending. A look at just the longer-term Securities (not T-bills) is even more convincing of the slowing of lending by foreigners:
This decrease in credit should pressure rates higher.And here is the breakdown of foreign investment into the U.S. Foreigners only continued to buy Treasuries, shunning new investment and selling off agencies in the riskier real estate market.
It’s not for nothing that the Goldman Sachs Secretary of the Treasury Timothy Geithner is hotfooting it around the world lately, last week to Saudi Arabia and the UAE… last month to China. The purpose of his trip, Geithner told reporters in Paris, he was doing this tour ”to make sure we keep working with governments around the world to continue to provide enough support to lift this global economy back to a sustained pattern of growth."Translation: Look here, we’re all in this together. If you jump ship now, we’re all doomed… DOOMED, I say! But the fact remains that the foreign holders of U.S. dollars have it within their ability – either deliberately or inadvertently as the result of a panic setting in – to literally destroy the U.S. currency. The latest report shows Russia and longtime monetary ally Japan edging toward the door. China and the oil-exporting nations continue to convert an increasingly moderate amount of their trade surplus into Treasury bills – but not on a nearly large enough scale to meet the inflated (and inflating) borrowing needs of the utterly bankrupt U.S. government. And how long will they continue to show up, when an increasing number of other foreign buyers start selling their Treasuries? No one likes to be the last one to leave a party, especially when the bananas flambé has tipped over on the floor and the curtains are on fire.Put simply, the only thing now standing between the U.S. dollar holding its own and an almost overnight debasement (and history has shown us that when things go wrong with a currency, they can go wrong very quickly) is the willingness of foreigners to play nice. This was never a threat that the Japanese had to deal with during the worst of their recent dark days, but it’s a very real risk here and now in the United States.That that risk sits on top of the monetary inflation that has been the steady response of the U.S. government so far – and will continue to be its response as the economy further erodes – is not something to be sniffed at.On July 17, Bloomberg reported that “China’s finance ministry failed to meet its debt-sale target for a third time in two weeks at a 182-day bill sale, according to traders at Galaxy Securities Co. and China Citic Bank in Beijing. The ministry had tried to sell 20 billion yuan of bills and only sold 18.51 billion yuan, traders said. The average yield for the bills sold was 1.6011 percent, they said.”
Here’s our take on this news item: The problem from the Chinese government's point of view is that they were not able to borrow as much money as they wanted, in the light that they are now spending at a very fast clip with a big stimulus program to keep their own economy (bubble?) growing. So how can they fund the spending? They can sell off the stash of foreign-currency-denominated holdings they are sitting on. That could mean Treasuries dumped on the world market.There are other alternatives, like getting the People's Bank of China to print up some new money for the government, which would inflate the renminbi (RMB) and decrease its international price and attractiveness. They might like to let the RMB fall to encourage exports and keep relative worker pay low on the world competitive scene. But they are also trying to make the RMB a world currency by itself, so they don't want it to look weak and at risk.Our guess is that they are selling Treasuries and not telling.

[Ed. Note: In latest news this week, Chinese Prime Minister Wen Jiabao said China “will use its foreign exchange reserves to support and accelerate overseas expansions and acquisitions by Chinese companies.” Jiabao called it China’s “going out” strategy. Going out (with a bang), though, may be a better description of what the U.S. will ultimately do.]

Gold, Silver, Oil and Nat Gas Technical Trading Setups

Commodities are trying to hold their ground and could go either way quickly. There is a lot of chatter going on about gold and silver. I am hearing extreme theories from everyone I talk with. Generally when I see the market get jumpy we tend to see volatility increase which translates into sharp rallies or sell offs.

My finger is on the trigger for Gold
Below are two charts of gold (GLD fund). The first one is what I would like to see before we have a low risk setup. This chart will not only lower the overall risk but increase the odds that the rally will provide more profit. Buying after a pullback actually helps to lower the down side risk because many sellers have been flushed out.

The chart below shows what could very likely happen tomorrow. If prices move higher and the intraday price action generates a low risk entry point I will be sending out an alert. This type of setup has a lower win rate but many times the rallies from these are quick and powerful. Locking in a profit is crucial when trading steeper trend line rallies.