The US natural gas cycle, from gas glut to gas shortage and back

There is someting of a gas cycle emerging in the US. This is due to some characteristics of the new unconventional gas sources, which need lots of capital and the wells peter out rather quickly, cutting supply, increase prices and incentives to start drilling again.

We’ve argued before that unconventional gas, especially in the US, is going through some considerable stress, even the big companies like Chesapeake have to cut back their exploration program to some extent. This holds more true for the smaller plays.

This cut-back in investment will lead to bigger gas shortages and higher prices in the future. But some companies might not make it till then.

Unconventional gas (like shale gas and coal seam gas) is a very capital intensive business, because wells need to be treated before they flow and the wells rapidly run out of gas, so lots of wells have to be drilled.

The double whammy of much tighter credit and falling natural gas prices (mostly a US phenomenon though, LNG in Asia, mostly traded through long-term contracts, is faring a lot better) is taking its toll.

Alert to E&Ps: This Is Not a Drill

  • “Drill, baby, drill.” U.S. gas exploration and production companies were way ahead of Republicans on that score. Now many are paying the price.
  • America’s natural-gas-drilling renaissance this decade has focused on unconventional reserves, such as “tight” gas. This coincided with two other trends: easy financing and a continuing shift by the majors towards non-U.S. projects.
  • Paradoxically, smaller independent companies took on the challenge of developing these large, complex fields. Tight gas requires lots of drilling, making it very capital intensive. Consider, for example, a holding of one million acres. Assume a well every 80 acres or so, costing $3 million each, and you’re looking at a bill of $37.5 billion — a multiple of most E&P companies’ market capitalization.
  • The great enabler was abundant financing. At the start of September, Credit Suisse analyst Jonathan Wolff was estimating U.S. natural-gas-focused E&P companies would reinvest 161% of hedged cash flow this year. Now, almost half the companies Mr. Wolff tracks carry debt loads of more than two times 2009 cash flow, assuming current spot energy prices hold.
  • As the credit crunch has intensified, the likes of Chesapeake Energy have slashed capital expenditures to conserve cash. They must also realign ambitions with reduced earnings power, since their very success in expanding U.S. natural-gas supply has undermined prices.
  • Given steep decline rates on tight gas fields, lower capex should quickly translate into less production, underpinning a recovery in prices next year. Until then, the more leveraged companies must try to survive.
  • For a growth sector, however, mere survival is not enough. As a whole, the group’s stock has dropped 65% since June 30.
  • Consolidation must happen. The majors have the strongest balance sheets and need growth assets.
  • The tricky part will be pulling off a deal. Imagine you are a Chesapeake shareholder, where the stock has collapsed from almost $70 in early July to $16 and change today. In that context, a cash offer of, say, $24 from a major would offer a way out, but not necessarily the most compelling one.
  • Dan Pickering, head of research at Tudor, Pickering, Holt & Co, an energy-focused boutique bank, puts it thus: “Investors want the validation of value from the majors, but they probably want it with a stock they don’t own.”
  • The likelihood is that if and when one of the majors makes its move — and BP PLC is said to be eyeing parts of Chesapeake — bosses at many E&P companies will rethink their stance on independence. Shareholders would probably prefer all-paper, low-premium deals among E&P companies themselves that cut costs, strengthen balance sheets — and leave them positioned to profit from natural gas’s attractive prospects after the credit crunch eases.

We think Chesapeake won’t be in the dolldrums for years, as production will grow less fast quite quickly, prices should recover next year, and, we have stressed it before in our recent writings on the company, they are quite pro-active, which is crucial in this environment.

No such worries for our Asian gas play InterOil though, they’re not producing LNG until 2014, and LNG is mostly traded in long-term locked in contracts which are much more stable.