These are challenging and uncertain times in the U.S. natural gas sector. Prices have fallen to levels not seen in decades, reaching levels that many consider too low to sustain development. Technological advancements and a huge influx of cheap capital have unlocked massive quantities of oil and gas resources that have flooded the market and have caused prices to collapse over the past several years. Nevertheless, U.S. gas production remains strong and has only recently shown signs of slowing. There is widespread speculation as to if and when prices will recover. Are low prices here to stay, or is now the opportunity of a lifetime for acquiring distress oil and gas assets?
As Figure 1 depicts, spot or current prices are set by inelastic (i.e., steep) supply and demand curves because they cannot quickly adjust to prices. Supply is much more price elastic in the long term because of the long lead times required to start production of new gas wells or wait for decline on producing wells. Similarly, demand also takes time to respond as businesses and consumers factor in prices in their capital stock (e.g., industrial processes, gas furnaces) decisions. As such, spot markets can be misaligned with long-term market fundamentals for a significant period. Hence, the key questions are: what will the market’s “new normal” (sustainable price) look like, and how do we get from here to there?
Figure 1: Transition from an Inelastic Spot Market to a Long-term Sustainable Market
To advise companies eager to understand and prepare for the next natural gas market transition, BRG proposes to initiate a multi-client study that will use its unparalleled combination of extensive expertise along the energy value chain and access to the best analytical models and data. The study will analyze the following critical industry issues:
- When and how will supply and demand respond to sustained low prices?
- What are the marginal supply basins?
- When will the supply overhang be burned off?
- How long will currently low prices persist?
- What will be the “new normal” in price?
- How will uncertainties such as oil price and volume of LNG exports impact gas prices?
The study will examine the U.S. gas market, including linkages to Canada and Mexico, over a 20-year time horizon. We will examine both short-term forces influencing market behavior and long-term market fundamentals. Figure 2 describes the primary analytical tasks.
Figure 2: Study Work Tasks
Task 1 is an in-depth analysis of gas production and drilling economics within each basin and is the foundation of the study. We will analyze the latest production data from DrillingInfo, a proprietary data service with detailed data on oil and gas production at an individual well level. We will analyze supply at a basin or sub-basin level, depending on their importance to the national market. For example, we will break out the Marcellus into five sub-basins, but Bossier and Jonah each will be represented as entire basins.
One crucial type of data will be initial production (IP) rates, which provide early indication of how productive wells in a particular location will be. By tracking production over time by well, we will derive a type curve to characterize production decline rates for each basin and estimate ultimate recoverable volume (EUR) per well. Figure 3 shows the distribution of IP rates for a particular basin and the implied break-even prices. The IP rate distribution (left chart) is highly skewed toward lower production rates in the sample basin, but this result is typical across all basins. We can estimate break-even prices from the IP rates by applying a type curve to project total production and then calculate the break-even price assuming a 10 percent internal rate of return. The distribution of break-even prices implied from the IP rates is shown in the right chart. Examining the distribution of break-even prices, we see that only about 30 percent of wells have break-even prices below $2.50. However, the prolific wells, even though few in number, drive the economics of drilling. This study will analyze what prices are needed to incentivize new production given the uncertainty in drilling productivity.
Figure 3: Distribution of Initial Production Rates and Implied Break-even Prices
In Task 2, we will analyze potential production by region over time. Examining production from producing wells is only the beginning of our analysis. We also need to estimate production from partially completed wells along with new wells. Figure 4 illustrates the potential productive capacities in the near term (i.e., next few years). In addition to current productive capacity from producing wells, the figure shows potential production from drilled but uncompleted (DUC) wells that await demand growth and/or price increases to make them economic. Since drilling costs have already been incurred, the marginal cost is just the completion costs. We also need to consider completed but not yet connected wells that cannot enter the market because of infrastructure constraints. As soon as infrastructure is built to connect these wells to market, they will start producing. New wells can also be produced but will require their full drilling and completion costs. Representing the different stages of well development and connection is extremely important because each stage has varying amounts of capital that have already been expended and therefore can be considered sunk. Future markets will be driven just by the marginal costs going forward.
Figure 4: Near-term Productive Capacity (illustrative)
Given the financial constraints driving near-term decisions of many oil and gas producers, the market might not respond as quickly as some might hope. Assuming the market will quickly transition from its current imbalance to a balanced market consistent with long-term fundamentals overlooks the critical question regarding “how we get from here to there.” Short-term considerations might affect producer decisions in a way that might appear inconsistent with long-term objectives. For example, despite sustained low prices, some highly leveraged companies need to maintain or even increase production when prices are low to service their debt. Further, short-term price hedges might shield some production from price fluctuations. The study will consider financial constraints that companies operate under in projecting near-term production.
Projecting U.S. supply and demand levels requires a sophisticated market model with detailed representation of supply, demand, and infrastructure. In Task 3, we will deploy ArrowHead Economics’ gas model, which embodies microeconomic principles in projecting prices and quantities. In particular, it represents depletable resource economics to project reserve additions and production volumes. It has a representation of the pipeline system including transportation costs and capacities. Supplies compete along pipeline routes to serve markets. The modeling logic has been used for decades by leading energy companies and governmental agencies. Figure 5 depicts reserve additions based on supply-demand dynamics.
Figure 5: Supply-Demand Dynamics
Under Task 4, we will perform a sensitivity analysis of crucial market and technical uncertainties. Given the range of uncertainties, a sensitivity analysis is vitally important to good decision making. We will run multiple scenarios to develop a range of potential outcomes and derive market insights. Study participants will be able to select from a prepared list a set of scenarios to analyze. Figure 6 shows some possible uncertainties that could be selected for the sensitivity analysis.
Figure 6: Market Uncertainties for Sensitivity Analysis
Finally, in Task 5 we will distill key findings and insights into a PowerPoint presentation. The deck will include key data and charts and be fully annotated. We will present interim and final results via WebEx meetings. In addition, we will provide individual presentations to each client at one of BRG’s offices (Houston, Washington, DC, San Francisco, or New York) or at the client’s site, if it is not too remote. The individual presentations will enable us to focus the discussion on each client’s particular areas of interest and maintain privacy.
Participants will be invited to project meetings and receive the following deliverables:
BRG experts leading the study
The study will be conducted by BRG’s team of highly experienced energy experts, including economists, geologists, and petroleum engineers, who have deep insights into the energy market. The leaders for the study will include:
- Tom Choi is a well-respected expert in natural gas economic analysis and strategy. He has conducted numerous market studies and advised global clients on major pipeline, storage, and LNG development projects during his 25-year career in management consulting. He will serve as the project leader.
- Rick Chamberlain is an oil and gas professional with deep experience in unconventional and conventional resource assessment and development. He has experience in more than 25 countries representing capital investments of more than $200 billion. He also has direct industry exploration experience, including developing and implementing Chevron’s Alaska Exploration strategy.
- Chris Goncalves leads BRG’s Energy practice and is a global gas expert. He has advised industry clients on large-scale energy infrastructure and commerce, including LNG, natural gas, oil, conventional power generation, and renewable energy. His experience in these fields spans the Americas, Eastern and Western Europe, Eurasia, and the Middle East.
Study timing and cost
The study is planned to commence in late May 2016, assuming a sufficient number of subscribers is reached. Results will be presented to clients in August or September. The cost is $25,000 for the full study, including all deliverables and a two-hour in-person presentation and discussion.
To subscribe or obtain more information, please contact Tom Choi at email@example.com or call 202.753.5834.
Is Recovery around the Corner, or Is This the New Normal for the U.S. Natural Gas Industry?
Tom Choi writes about the natural gas exploration and production industry, reductions in capital budgets, and the industry's chances to recover from the recent fall in prices. Read the paper.