Natural Gas Not Likely to Explode

 | May 14, 2012 | 4:00 PM EDT
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Traders waiting for natural gas prices to explode may have to wait a long time. Dreamers argue that future prices are in contango. Others suggest there will be a price reversion toward a mean. But these arguments are just illusions as industry fundamentals will continue to hold prices down.

It's true that future prices for natural gas are in contango. Forwards or futures contracts are trading above the spot. But after adjusting for seasonality, it is a messy curve and there is not a lot of liquidity. Without liquidity, price discovery is difficult and somewhat meaningless.

In the alternative, some analysts argue that the price of natural gas will ultimately revert to some mean. Their argument assumes fundamentals will remain unchanged and normal market forces will dominate pricing. Natural gas is not an international commodity and pricing in North America is mostly influenced by industry fundamentals. While there may be a movement toward a mean, the important question becomes, what is the new mean?

There are rock solid market fundamentals framing the industry, which influence pricing. The critical argument is producers will not stop delivering natural gas.

There are at least three reasons why natural gas will continue to flow. First, there are lease provisions for land rights used by many exploration and production companies like EOG Resources (EOG), Noble Energy (NBL), Southwestern Energy (SWN) or EQT Corporation (EQT). They employed a "use it or lose it" provision called, "held by production" (HBP). Under HBP leaseholds, natural gas must be produced in order to maintain, or "hold," a lease. Because of HBP, gas is produced uneconomically in order to retain control of the acreage.

Second, natural gas production is growing in association with the production of crude oil. As oil prices rise and natural gas prices fall, producers are shifting focus to shale basins containing crude oil. Natural gas is often produced along with crude oil. Associated natural gas production has grown to roughly 10 percent of total natural gas produced.

The amount of associated gas can be significant. Chesapeake Energy's (CHK) Utica experience suggests that for every barrel of oil produced in Ohio, 58.87 million cubic feet of natural gas is also produced. If a company thinks of itself as being in the oil business, its natural gas production costs are essentially zero. They can afford to sell natural gas for $2.00 and make money.

Associated gas is likely to grow more as drillers seek oil locked in rock and shale like Bakken and Utica. Historically, this type of natural gas was considered a waste product and was burnt off in gas flares. But the flaring of associated gas introduces an air pollutant, which caught the attention of the Environmental Protection Agency (EPA). The EPA referenced the Clean Air Act and finalized <a href="">New Source Performance Standards</a> (NSPS) for the Oil and Natural Gas Sector. For new wells, the EPA defined "reduced emission completions and combustion of escaping gas" as the Best System of Emission Reduction (BSER). Flaring will be allowed until Jan. 1, 2015, to allow time for BSER equipment to become broadly available.

The flaring of natural gas in the Bakken play is about to end. According to the Oil & Gas Journal, Oneok Partners LP (OKS) plans to build a 270-mile natural gas gathering system in North Dakota. The system, which is expected to be completed in the second half of 2013, will gather and deliver natural gas from producers in the Bakken shale to new gas processing facilities. The new gathering system will allow Oneok to fill all four of its gas processing plants in the Bakken shale and Three Forks regions. This project is in addition to other Bakken natural gas projects, which include a 500-mile natural gas liquids pipeline and three 100-million cubic feet per day gas processing facilities.

Third, new drilling technologies will add even more oil and gas supplies at lower production costs. Fracking technologies are evolving at a rapid pace. Lawrence Livermore National Laboratories is creating sophisticated simulation tools that enable new drilling and completion strategies. Yields, which typically range from 8%-13%, are increasing as fracking technologies become more sophisticated. These technologies currently permit producers to restimulate existing wells to achieve even more production

While Boone Pickens has called a bottom and Chesapeake claims major price recoveries are in the making, industry fundamentals suggest only modest gains are possible. Dreaming that $7.00 natural gas is around the corner is just that, a dream.

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