Phillip A. Ellis
Vice-President
Booz*Allen & Hamilton
Dallas
This is the first of occasional articles on petroleum management issues.
This is an anxious time for production and transportation of natural gas in North America.
Prices have tumbled to a level that is causing serious stress in the industry. Columbia Gas is the most notable example of a player that has reached the breaking point, and other company crises are certain to occur upstream and downstream.
Prices must rise substantially for all but the top 25% of exploration and production companies, based on finding costs, to create wealth for their owners. As a result, most companies continue to scale back their drilling outlays. The average performer simply will not survive very long in this climate.
FORECASTS USEFUL?
In this environment, what do recent price forecasts tell us? Are these forecasts of any use? Or are they more distraction than insight?
For years, industry participants have been hearing from forecasters that the gas supply bubble is about to burst. Yet it persists.
Some argue that the "3 year bubble" has become one of the few constants in business.
Even though most of us find it hard to imagine that prices can go lower, the fact is the variable costs of production suggest where, in theory, the rock bottom may be. That level is about 60/Mcf.
Few observers, if any, expect the price to plummet to such levels, but even the possibility of such a floor is disturbing.
Yet, forecasts from most firms that have investigated supply and demand are reasonably optimistic from the producer's perspective.
Our firm recently reviewed projections of several industry analysts.
We excluded forecasts that assume flat real prices forever. Those include some major banks and a few major producers.
We also excluded forecasts on the very high side, such as one calling for a spike in gas prices in 1994 based on a spike in the price of oil.
The average price increase in real terms (1991 dollars) for the forecasts we consider to be most thoughtful is 10%/year through 1995. Within this sample of forecasts, however, variations are considerable, ranging from $1.60 at the low end to $3 at the high end, with a consensus forming around $2.10.
It will take real increases of 10%/year to reach such a level, assuming an initial price of $1.45 for a 1991 average.
(Plug in your favorite 1991 price).
It should be no surprise that investments made in exploration and development will create wealth-returns exceeding the cost of capital-for the average finder if prices grow at 10%. But the average explorer/developer will destroy wealth if prices do not rise at that pace. At flat real prices, very few companies should drill.
It's no wonder forecasts are viewed with such interest.
ASSUMPTIONS CRITICAL
A look at assumptions behind the forecasts raises questions about supply and demand as well as the approaches of companies making the forecasts. These insights are at least as critical to the industry as price projections that result because a company should agree with the assumptions to believe the prices projected.
For example, most firms arrive at higher prices by assuming that growth in gas demand will exceed growth in deliverability and oil and gas prices will recouple. Most of these firms believe higher prices will stimulate drilling in a way that builds supply fairly quickly, which will prevent price spikes.
In those scenarios, gas is viewed as a premium or preferred fuel for which demand will grow strongly due to environmental and other concerns.
But there are sharply contrarian views among other industry analysts.
Forecasters at the low end of the range believe gas on gas competition will continue through most of the decade and the resource base is ample. In particular, these forecasters believe tight sands and/or coalbed methane sources will help keep the bubble alive.
We, on the other hand, stand toward the higher end of price projections, with rises driven by a combination of:
- Continued declines in deliverability and very slow response in supply to price increases.
- Less growth in demand as switchable demand returns to oil if gas prices rise too quickly-if such switches are environmentally acceptable.
We believe new fields are becoming too small, on average, to drive a rapid replacement of required gas. Our view is that the gas bubble is about 2-3 tcf in North America but is shrinking at about 1 tcf/year.
While we are optimistic about tight sands and coal bed methane, these sources will not provide enough added supply to change the overall decline in deliverability. In fact, these tax incentive sources may be diverting funds from higher deliverability prospects.
For the brave, this view suggests that the next few years may provide substantial opportunities for investment in the natural gas business.
The reason is no more complex than "buy low, sell high."
Copyright 1991 Oil & Gas Journal. All Rights Reserved.
