The U.S. natural gas market — and thus, long-term gas prices — won’t be upended because of the unconventional resource “revolution” because marginal costs ultimately determine gas prices, according to Morningstar.
Morningstar’s Mark P. Hanson and Jason Stevens said the claims by gas bears of a “new normal” in domestic gas markets aren’t supported by the underlying data. To determine whether a market “revolution” was shaping domestic gas prices, the duo examined gas rig productivity, associated gas and natural gas liquids (NGL), efficiency gains and marginal costs. They found that shale gas production “is more evolutionary than anything, especially when it comes to costs, which ultimately determine prices.”
Beyond a “radically improved production process or a new, low-cost supply source, we don’t foresee any meaningful structural change in the cost to produce natural gas going forward,” wrote Hanson and Stevens. The domestic gas rig count tends to be a “poor” prognosticator of domestic volumes over shorter periods of time. And 2012 was one of five in the past 20 years when U.S. output “remained stubbornly high.”
Higher associated gas output also isn’t a “new phenomenon, nor has it become a more dominant feature” of U.S. volumes in the past few years, even with the shift toward oil-rich plays. Morningstar’s analysis “suggests that neither associated gas nor liquid-rich gas represents a meaningful threat to a sustained recovery” in prices over the next few years.
In addition, said the duo, efficiency gains promoted by upstream operators tend to present them in the “best light,” but the measures “can be highly misleading.” Even with the shift to unconventionals, “oil and gas production will never approach the repeatability of a true manufacturing process.”
More striking data points are marginal costs, said Hanson and Steven. Over the past 10 years, the marginal cost of gas output has been “$5.00-7.00/Mcf, with an average of about $6.00” and “appears to be mean-reverting” with fluctuations mostly a function of oilfield service prices.
Morningstar’s current marginal U.S. gas cost forecast is $5.40/Mcf because analysts believe prices are expected to converge in the next few years. The latest forecast is down from a previous estimate of $6.50/Mcf, mostly because of updates to methodology.
“Over the past 15 years, the top 25 domestic gas producers invested more than $800 billion in their upstream operations. Close to 80% of this figure — roughly $640 billion — went toward drilling and completion costs and unproved leasehold acquisition, and the vast majority of this amount was spent on services,” said Morningstar’s team.
“Prices for oilfield goods and services are set by an increasingly powerful group of suppliers, which means that E&Ps rely more on operational improvements than bargaining power to drive down costs over time. In addition, capital investments can represent more than half of a well’s total outlays and are more ‘one time’ in nature than operating expenses like lifting or transportation costs, which make them an obvious focal point for both E&Ps, as well as our analysis of industry-wide efficiency.”
More energy analysts continue to believe that gas prices won’t recover this year because of mild winter weather. The domestic price recovery “shoves a $4.00-plus” price to the second half of this year, said Canaccord Genuity’s John Gerdes. Canaccord’s average 2013 gas price forecast remains “unchanged at $4.00, though it now reflects a $3.50 gas price early in the year and $4.50 later this year.”
Longer term, said Gerdes, maintaining market equilibrium will require an increase in gas-directed drilling activity by 30%, or 575 gas rigs. A $5.00 New York Mercantile Exchange (Nymex) gas price “appears necessary and consistent,” assuming the exploration and production (E&P) industry is 10% free cash flow negative.
Since the start of the injection season in November, the year/year storage overhang of 900 Bcf “has been eliminated on the back of 4 Bcf/d-plus stronger gas-fired power demand, Gerdes said. “In a $3.00/Mcf gas price environment, gas-fired power generation served as the corrective mechanism to reduce the storage surplus.”
Gas prices may have reached their nadir last April, according to Gerdes. “Given our $4 gas price expectation this year, we expect gas-fired power to decline almost 2 Bcf/d in ’13 as coal-fired generation recovers half the coal-to-gas displacement that occurred in 2012,” which reconciles with the structural de-emphasis on coal-fired power.
Canaccord’s “favorite” E&P names emphasize development over the next year in the Marcellus Shale for gas and in the Eagle Ford Shale for oil. “In our view, the E&P sector reflects $75-77.50 Nymex oil and $4.50-4.75 Nymex gas,” with prices expected to average $90/bbl and $4.00/Mcf.
CIBC World Markets’ Katherine Spector, who is head of commodities strategy, said she is “not bullish, but less bearish” about North American gas prices. CIBC is forecasting an average 2013 Henry Hub price of $3.40/Mcf unless there is a “sustained bout” of extremely cold winter, which now appears unlikely.
Meanwhile, Morgan Stanley has lowered its 2013 gas price forecast to $3.50/Mcf from $3.90, also citing warm winter weather. “December proved unusually mild, and the forecast for the remainder of the withdrawal season reads milder than normal,” Morgan Stanley analysts said. “In the face of these forecasts, our tactically bullish gas call for (the first quarter) will almost certainly not materialize.”
Teri Viswanath of BNP Paribas also weighed in on gas prices Tuesday. “Though we cautioned that natural gas prices would remain vulnerable to possible demand weakness, we were optimistic that gas deliveries would average $3.60 during 1Q2013. Now, however, we suspect that excess winter inventories will keep prices below $3.50 until the second half of 2013.”
The second half of 2013 “will likely meet a more sluggish recovery given the limited prospect for demand growth,” Viswanath wrote. “The slow ebb of inventories that we envisage implies $4.00 prices are only likely to emerge in 2014.”
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