Is $3/MMbtu new floor for US gas output growth?

May 27, 2002
Getting a handle on the future of natural gas prices usually means analyzing all the cross-currents of supply and demand. Casting a sidelong glance at what oil prices are doing also becomes necessary at times to get a fix on gas prices.

Getting a handle on the future of natural gas prices usually means analyzing all the cross-currents of supply and demand. Casting a sidelong glance at what oil prices are doing also becomes necessary at times to get a fix on gas prices.

Now we have analysis that posits that US gas prices will be roughly at market equilibrium starting with a floor of $3/MMbtu (Henry Hub), because that's the price producers need for a decent return on investment.

Thomas Driscoll, analyst with investment banking house Lehman Bros., set aside the usual divinable entrails of gas supply and demand to take a close look at the costs of finding and producing that gas-for the purpose of developing a midcycle price forecast that makes sense. That approach left him forecasting Henry Hub gas at an average $3/MMbtu in 2002 and $3.50/MMbtu in 2003.

New approach

Driscoll, in a May 10 research note, said, "Many observers of the natural gas industry [including us] have spent a lot of time trying to assess production decline trends, natural gas import growth, [and] the prices of competing fuels, as well as future demand growth and many other variables in an attempt to forecast future natural gas prices."

Driscoll contends that one of the toughest gas market elements to gauge is the interplay between natural gas prices and demand, citing the decline in gas demand of only 15% last winter when gas prices were averaging $7/MMbtu.

Assuming a 10% internal rate of return (IRR) to justify drilling gas wells, Driscoll concluded that, over time, the cost of finding, developing, and producing natural gas-plus an adequate return on capital-should determine midcycle pricing.

Rising costs

Driscoll's analysis found that, while reserve sizes have shrunk and costs have risen, technology advances have bolstered success rates and improved completion techniques. Thus the higher level of initial production rates and more-rapid field depletion have offset some of the increase in finding and development costs.

Driscoll pegged US F&D costs as having risen from $0.85/Mcfe in 1992-94 to $1.15-1.25/Mcfe the past 4 years. He projects them remaining at $1.25/Mcfe.

While finding costs have risen, cash operating costs have remained relatively constant, because rising lease operating costs have been offset by falling unit overhead costs. The forecast for cash costs, including overheads and wellhead revenue taxes, is an average $0.95-1.05/Mcfe.

Shrinking cycle time

Meanwhile, according to the Lehman Bros. analyst, the time lag between capital and cash flow has shrunk with the steeper decline curves.

"The estimated lag between first production and production of the average molecule has fallen from an average of 4.7 years in 1990 to 3.9 years today," he said.

This 2/3-year drop at a 10% cost of capital results in a decline of 8% in the gas price that the producer needs for a decent IRR. The upshot of all of this is that the cost of producing gas has risen by 3%/year since the mid-1990s, Driscoll contends, which leaves producers requiring $3/MMbtu for an adequate IRR.

Outlook

Well, $3/MMbtu gas has reappeared on the scene only recently, and despite the previous winter's spike, has been generally shy in recent years.

That is why Driscoll reckons that US gas production will be down 8.3% this year from the 1998 peak.

"Although we believe that recent drilling investments would be justified by a $3/MMbtu average gas price, we do not believe that production will grow in a $3/MMbtu environment," he said. At the same time, Driscoll says that a gas price above $3/MMbtu may be required to keep a lid on soaring demand and thus prevent another cycle of tight supplies and price spikes.

"If potential demand growth outstrips supply growth, the gas price will need to rise," he said. "The challenge to the industry will be to maintain enough capital discipline to keep its costs low enough to allow it to earn returns in excess of its cost of capital. This challenge may prove insurmountable in a highly fragmented industry."

Sounds pretty much like another prescription for continuing volatility.

(Online May 17, 2002; author's e-mail: [email protected])