WHY RISING U.S. GAS DEMAND MAY NOT HIKE PRICES IN THE '90S

M.A. Adelman
Massachusetts Institute of Technology
Cambridge

It was widely believed after the 1986 U.S. natural gas price drop that prices had to rise steeply soon because at the low prices it did not pay to replace reserves.

Lack of reserves would push the price back up.

This forecast raised the value of reserves in the ground.

It was a mistake.

Reserves were replaced because the cost had dropped so sharply that it paid to replace them.

This fact was hidden by the so-called "finding cost per Mcf equivalent." This is expenditures on exploration plus development, for oil and gas together, divided by the reserve-additions of oil plus gas reduced to an equivalent, usually of 6:1 but sometimes a higher ratio.

This procedure adds apples to oranges and divides by bananas plus grapefruit.

It makes no sense because exploration is not development, and oil and gas cannot be reduced to any common economic denominator. Development in oil may be unprofitable while gas is profitable, or vice versa.

COST CALCULATIONS

The confusion is unnecessary.

The American Petroleum Institute publishes total development expenditures and oil and gas development drilling expenditures.

Since drilling expenditures are about two thirds of the total, allocating that total by drilling expenditures cannot be far wrong.

This yields an estimate of gas development capital expenditures, which should be divided by the gross additions to nonassociated gas reserves, which are depleted through gas wells (see table).

Individual years jump around somewhat, but the main picture is clear.

In 1984-85, replacement cost was about $1/Mcf, and since then it has been about 45 cents/Mcf.

The 1990 cost was probably lower than 1989, since the number of gas wells drilled--a fairly good index of expenditures--rose 6% while the total reserve addition rose 20%.

RESERVE VALUES

The industry rule of thumb is that a reserve unit is worth about one-third of the wellhead price; that is, it doubles the cost to hold the asset until it is produced and sold.

Another 50% must be added for operating expense, taxes, etc. The author's own research has shown that the rule is well borne out in experience since 1947.

Thus if gas can be sold at $1.65/Mcf, it is worth finding at 55 cents/Mcf or less.

Declining cost might be partly due to fewer and better reserves added as operators concentrate on the better prospects and ignore the poorer ones. But in fact more has been added to reserves per year since 1985 than earlier.

Coalbed methane has not been important. The U.S. Department of Energy estimates net coalbed methane reserve growth at 1.4 tcf in 1990, and 400 bcf is probably an overestimate of production. The total 1.8 tcf is 11% of the gross reserve additions of 1990.

Gas completions in 1991 were down. Perhaps the good development prospects have been used up and costs will now begin to rise. We must await evidence that this is happening.

So far, low gas prices have been stable because they have induced enough profitable development to maintain the reserve inventory. Rising gas demand during the 1990s may not suffice to raise gas prices.