WILL PRODUCERS BENEFIT WHEN (IF) U.S. GAS PRICES RISE IN EARNEST?

Robert H. Caldwell, Wayne A. Beninger
Scotia Group Inc.
Dallas

Gas prices at the wellhead in the U.S. during summer 1991 were the lowest in more than 10 years, bottoming out at about $1/Mcf.

The purpose of this article is to provide a brief historical perspective on where the U.S. gas exploration and producing industry is and how it got here. This is useful background in placing the current dilemma of the gas producer in perspective and in documenting what an industry cycle looks like.

GAS PRICE TRENDS

Energy Information Administration data show the historical price trends (Figs. 1, 2).

The first figure shows the price received on an average U.S. basis at the wellhead and burner tip. The second shows the differential; i.e., the percentage of burner tip gas price received by the producer at the wellhead.

Before the 1980s, the gas industry was regulated with producers selling directly to pipeline companies who sold to distribution companies at the city gate or effectively owned such distribution companies themselves.

With the 1980s and partial deregulation of the gas industry, pipelines became common carriers, and another middleman appeared in the form of gas marketing companies.

Deregulation's purpose was to allow producer to end-user contracts, but for the small producer it in fact introduced another layer of middlemen. The effect was that with the Natural Gas Policy Act of 1978 and increases in oil prices during the late 1970s, gas prices were dragged higher.

Since the local distribution companies were regarded as regulated utilities, much of the price rise was passed back to the producer, reflecting an increased share at the wellhead of total burner tip gas price.

PRICE SHARES SHIFT

As such, the producer share rose from 30% in 1973 to about 55% in the early 1980S.

With the deregulation of gas and the introduction of gas marketing, the producer share has dropped now to less than 40%, with the differential being taken up by the middlemen.

If one regards this as a cause and effect relationship, then it could be anticipated that some passthrough of a future price rise would end up back at the wellhead for the same reasons as observed in the past; however, this would be buffered by the increased take of the middleman in the form of gathering, common carrier pipeline, and gas marketing companies.

Where does this leave the industry?

As previously mentioned, gas prices this summer were the lowest in 10-15 years, bottoming out at around $1/Mcf.

That price appears to be the floor in that many of the larger producers will shut in reserves rather than sell them at these prices. This was observed for several months and resulted in a slight rebound of gas prices.

PRICE HIKE ANTICIPATED

On the other side of the coin, based on figures from the Scotia M&A Database, production acquisitions involving predominantly gas reserves have continued a 3 year trend of overall increase based on reported dollar paid per thousand cubic feet equivalent in the ground despite falling gas prices.

Since purchasers will base their bids upon cash flow projections, one can only conclude that the observed increase in dollars per thousand cubic feet equivalent paid represents a more and more aggressive escalation profile used in constructing such cash flows; i.e., the industry is expecting a major rebound in gas prices.

This view is supported by price projections such as those of John S. Herold (OGJ, Aug. 19, p. 29), which show a marked departure from historical price trends (Fig. 3).

The industry had expected a dramatic rise in prices for at least 3 years and as many as 5 years. Instead, we have watched the bubble elongate and wellhead prices fall.

FACTORS DELAYED

It appears that the prime factors being touted as likely to cause a gas price increase--these being environmental legislation, increased demand, and nonreplacement of supply--have not materialized or are at least delayed.

This is surely the case so far for environmental legislation and, on the supply side, tax incentives for coalbed methane and tight gas have leveled off the reductions in supply, prolonging the surplus.

We appear to be at the base of the price cycle but already on the incline for the last 2-3 years of the business cycle, as evidenced by the acquisition prices.

This may not be a bad thing in that at least while one might have to pay a bit more for reserves in the ground, we at least won't have to suffer declining gas prices for that many more years until, hopefully, prices go on the rise again.

However, don't expect that price increases will all flow back to the wellhead. For the small producer unable to market his own gas, a significant proportion of the price increase will be absorbed between the wellhead and burner tip.

Copyright 1991 Oil & Gas Journal. All Rights Reserved.