Natural-gas output cuts grow as prices languish

Natural-gas producers have been announcing reductions to output levels lately, and that could be the start of a new trend that helps rejuvenate the fuel’s prices, which have languished at levels that are unprofitable for many producers.
Chesapeake Energy Corp., the second-largest U.S. producer of natural gas, on Monday said it plans to slash dry gas-drilling capital expenditures to $900 million this year, from $3.1 billion last year; curtail roughly half a billion cubic feet per day, or 8% of its gross gas production because of low prices for natural gas; and possibly even double that output reduction if conditions warrant.
“If producers show discipline in shutting in production and there is more demand for natural gas from utilities switching from coal to natural gas, then we could get back above $3 million British thermal units pretty quickly,” said Matt Adams, portfolio manager of the Franklin Natural Resources Fund.
Natural-gas futures fell 4.5% Thursday to $2.61 per million British thermal units. They touched their lowest level since 2002 this month and have lost 15% year to date.
This week, Occidental Petroleum Corp. announced that it will cut back on pure gas drilling due to “horrible” natural-gas prices, ConocoPhillips said it continues to limit investments in North American gas production and Consol Energy Inc. said it’s scaling back its development plans in its Marcellus Shale gas fields this year.
Against that backdrop, futures prices for natural gas logged a four-session gain of more than 15% as of Wednesday, though that doesn’t outpace the 24% decline they suffered during a recent eight-session losing streak.
Production cuts have “changed the market psychology,” according to Phil Flynn, a vice president at PFG Best. “We may have hit the point where producers are saying ‘No more.’”
“This is the first thing that the bulls have had to hang their hats on. Everything was bearish,” he said. “I still think that we could see gas go under $2, but the market is worried that more cuts may come.”
With producers currently releasing fourth-quarter earnings along with 2012 capital-expenditure budgets, that may be a good bet.
“I expect nearly all natural-gas producers to announce a much more aggressive transition away from gas development and into oil for 2012,” said Ben Smith, president of energy data and information provider First Enercast Financial. “Those that don’t make some sort of change or statement will be vulnerable to stock-valuation punishment from Wall Street.”
Drilling for profit
Indeed, profiting from natural gas at current levels has proven difficult for producers.
“Even before gas dropped sub-$3, we saw that producers were cutting back Haynesville and other dry-gas activity to the bare minimums required to keep leases,” said Kim Pacanovsky, managing director of oil and gas at boutique bank MLV & Co. The Haynesville basin is located in Louisiana, East Texas and southwestern Arkansas.
“There are certainly more opportunities to scale back and others will surely follow suit,” she added.
Chesapeake, Occidental and ConocoPhillips are “cutting back because the gas is worth more in the ground than it is if produced and sold today,” said James Williams, an energy economist at WTRG Economics.
“Few companies can afford to drill for gas and produce it at these prices,” he elaborated, and “most companies cannot break even drilling a new dry-gas well” at the current price levels.
The majority of U.S. natural gas comes from dry-gas wells. Natural gas is considered “dry” when it is almost pure methane, with most of the other commonly associated hydrocarbons removed, according to NaturalGas.org.
What the minimum price for natural gas must be for producers to profit “varies from company to company depending on the company’s contracts, for example,” according to Mark Stansberry, chairman of the GTD Group, an energy-management firm.
“There are some companies that are at a point where they are needing to move away from natural gas and others that may be able to withstand the current low prices for some time,” he said.
But for most dry-gas regions, producers need $3 to $4 per million BTUs just to break even, said Pacanovsky, so “almost all dry-gas regions are unprofitable at current prices.”
Franklin Natural Resources Fund’s Adams said there should be “little or no drilling of dry natural-gas wells [wells that do not have oil or natural-gas liquids] occurring right now.”
But “natural-gas hedges at higher prices, more borrowing capacity on bank revolvers and capital infusions through joint ventures with major oil companies” can allow producers to keep drilling for natural gas through periods of price weakness, despite negative cash flow, he commented.
Fuel for low prices
Prices in 2008 hit highs above $13 and several factors have contributed to a drop of around 80% in natural-gas prices since then, including hefty supplies and growing shale-gas production.
Improvements in technology like hydraulic fracturing (a method used to release gas in rock formations) have allowed for more shale-gas production, said James Hug, portfolio manager at Yorkville Capital, noting that shale gas has grown to represent about 30% of U.S. production, with some estimates showing potential to represent as high as 50%.
Warmer winter weather than usual throughout much of the country also has helped build a supply glut.
“Average winter temperatures 4 degrees warmer than last year ... have kept seasonal demand low and we are poised to leave the winter at high levels of production and unseasonably high levels of gas in storage,” said Badar Khan, president of Direct Energy Upstream & Trading.
Natural gas in storage stood at 3.1 trillion cubic feet as of the week ended Jan. 20, according to the U.S. Energy Information Administration, with stocks 547 billion cubic feet above the five-year average.
“These elevated inventory levels, and the approaching end of the peak winter gas-demand season, finally prompted energy firms to take action and curtail their gas production,” said Alan Herbst, a principal at Utilis Advisory Group.
Several other significant gas producers will need to cut their production by an amount similar to that of Chesapeake, he added. If that happens, “natural-gas prices will most likely recover and hold at $3 to $4 through this year and next until greater amounts of demand enter the market to absorb the additional gas supply.”
Prospects
For now, except low prices and high volatility.
“The lows will be determined by short-term market dynamics,” said Khan. But “it’s not simply the short-term production and storage dynamics that are driving this volatility. The market is still coming to terms with exactly what shale gas is going to mean for our economy, and the industry is evolving in real time.”
Meanwhile, price increases won’t occur unless a “meaningful export market develops or usage of natural gas begins to replace oil as a fuel in a more meaningful way,” said Mickey Cargile, managing partner at Cargile Investments.
Still, “low price and excess supply in a capitalist economy will eventually find its own demand,” he noted.
That’s especially true as oil prices trade around $100 a barrel.
The transition away from gas to oil already has begun, and “without further investment focus on natural-gas production, supply will eventually drop quite quickly,” said First Enercast’s Smith.
“Once we get past March, I am actually very bullish on the gas market,” he added. “The amount of coal-to-gas switching [that low gas prices] have attracted recently, along with expectations of a large utility-maintenance event this spring could quickly snap prices back above $3 this spring and into summer.”
Source: Market Watch