The note below is from Lou Gagliardi, our recently-launched Sector Head of Energy. If you'd like to trial his energy sector research, which includes access to the replay of his launch presentation on natural gas, crude oil, and opportunities in the global E&P sector, please email email@example.com.
Position: Short natural gas (UNG)
Conclusion: Advances in drilling technology are way ahead of the demand curve, creating excess inventory which puts downward pressure on price that could lead to a prolonged period of oversupply.
As we stated in our Energy Sector launch yesterday, we are bearish on the outlook for natural gas for three key reasons: demand, human behavior, and technology. Today we want to focus on the technology aspect of the bear case for natural gas.
The increasing utilization of horizontal drilling and hydraulic fracturing in combination as production methods of tapping into unconventional natural gas shale plays in the lower 48 over the last several years has rocketed U.S. natural gas production. When demand re-emerges, indications are that production will chase price leading to a natural gas oversupply situation. Surprisingly, the U.S. Department of Energy (DOE) through its Energy Information Agency (EIA) is forecasting flat natural gas demand for 2011, but (surprisingly) higher prices. We obviously disagree.
Some key facts to consider as it relates to our thesis:
- U.S. Gas production peaked in about 1974 and finally turned higher in 2005 due to increasing utilization of horizontal rigs and hydraulic fracturing (highlighted in the charts below).
- From 2005 to 2010 (YTD), U.S. gas production increased ~20%. In that period gas rigs declined ~20%, but horizontal rigs increased 325% (vertical rigs declined 77%).
Horizontal drilling technology
- Horizontal rigs have increasingly displaced Vertical rigs; today roughly 65% of overall rigs in the US are horizontal rigs (highlighted in the charts below).
- Horizontal rigs generate greater production flow rates than vertical rigs, due to greater contact area with reservoirs.
- While horizontal drilling incurs higher costs, as much as two or three times that of a vertical well, the production factor can be increased as much as 15 or 20 times.
- Additionally, horizontal drilling can lead to an increase in reserves in place by 2% of the original oil in place. The production ratio for horizontal wells versus vertical wells is ~3 to 1, while the cost ratio of horizontal versus vertical wells is only ~2 to 1.
- Horizontal drilling has reduced drilling and completion costs to under $4.00/Mcf from over $5.00/Mcf. By contrast, the marginal cost of US gas production from conventional vertical wells averages ~$6.00/Mcf.
Access to unconventional assets
- Today, roughly half the natural gas consumed in the U.S is produced from unconventional wells drilled within the last few years made accessible by new drilling technology.
- Unconventional gas production accounts for nearly 50% of total U.S. gas production.
- Reportedly breakeven costs for U.S. unconventional gas plays range from as low as $3.30/Mcfe in the Marcellus, and $3.66/Mcfe in the Fayetteville and Horn River to $4.43/Mcfe and $4.79/Mcfe in the Montey and Haynesville, respectively.
- Drilling (horizontal) technology has enhanced deepwater exploration in areas such as Brazil (Sub-Salt), Gulf of Mexico (GOM - Lower Tertiary); and unconventional resource plays in areas besides the lower 48, as the Canadian (Oil Sands-In-Situ), Europe, China, and other unconventional plays such as Tight Gas Sands, and Coal Bed Methane.
Pent up supply
- In a low gas price environment companies have sought to restrict flow rates, slowing production, to focus on maximizing “ultimate gas recovery”.
- High production rates reduce a reservoir’s permeability, by slowing the production flow rate; you slow the “decline curve” and increase potential estimated ultimate recovery (EUR) rates.
- Reducing the flow rate also defers the need for capital intensive compression, which comprises roughly a third of operating costs.
- Restricted flow rates can likely increase the recovery factor from 30% to 40%.
- Hydraulic fracturing enables the production of natural gas and oil from generally 5,000-20,000 feet.
In aggregate, advances in technology related to horizontal drilling and fracturing allow E&P companies to access natural gas reserves in areas that were once considered unconventional. The impact of this is a lower aggregate cost to access the natural gas, and less steep decline curves. As a result, production outstrips long term domestic demand growth, which we measured at ~0.5% per annum over the last thirty years.
Natural gas supply and demand facts don’t lie; DOE projections for price do.