Economists' Corner

Like a stubborn cowboy strapped to the back of a bucking bronco, gas producers hung on for a wild ride throughout 2009. Increasing production, falling demand, brimming storage, a limping global economy and the forceful shove by legislators toward carbonless energy acted as burrs under the saddle of managements’ growth plans.

“The gas industry is still caught in the crosscurrents,” says Barton Smith, a University of Chicago-trained economist. Smith teaches at the University of Houston and heads its Institute for Regional Forecasting. “We have sufficient supply but too little demand. We have found so much gas during the last four years.”

Indeed, shale-gas producers are victims of their own success, and there is no end in sight. According to a recent report by Scottish consulting firm Wood Mackenzie, U.S. gas production from shales could reach 30 billion cubic feet per day by 2025, up some 154% from today. At that rate, shale gas would comprise one-third of total domestic supply. Total gas production will reach some 70 billion cubic feet per day, long term, given the huge resource base, asserts the firm.

Typically, levels of gas production are predicated on a rise or fall in the regional rig count. Thus, gas producers looked for a drop in production when, after a peak in October 2008, the rig count fell by more than 50%.

But the hoped-for production decline failed to appear. After analysis, it’s clear that the rig-count collapse was far more significant in nonshale regions. Because rig counts in the Bakken, Barnett, Haynesville, Fayetteville and Appalachian regions did not fall as much as in other areas, and because those plays account for a disproportionate share of the modest rig-count recovery thus far, shale wells (which have high production rates) have supported production beyond most forecasts.

Overall, Lower 48 production trends held mostly steady with an uplift in August due in part to Marcellus-driven growth in Appalachia. Also, Gulf of Mexico gas production has moved sharply higher since September 2008 due to recovery from outages caused by hurricanes Gustav and Ike.

"We have sufficient supply but too little demand. We have found so much gas during the last four years," says Barton Smith, an economist at the University of Houston

But at year-end 2009, the latest figures from the U.S. Energy Information Administration showed that Lower 48 production had slipped by 1.39 billion cubic feet per day in September from the prior month, representing a 2.2% drop—the largest since September 2008.

Specifically, Wyoming production began to edge lower, although not by much. Oklahoma’s production was down from its peak, but the decline was mild. As such, prices are not expected to climb any time soon due to short supply.

Boom and bust

The period between 2007 and 2009 epitomized the boom-bust cycle of energy, says Smith. “In 2007, 85% of all domestic exploration in the U.S. was for natural gas. That gas boom caused rapid growth in the oilfield manufacturing sector, centered almost exclusively in oilfield equipment used to search for gas in Texas, Wyoming, Colorado and New Mexico. It took several years to bring the gas online. Unfortunately, it came online just as the American economy was going south. Hence, the 2009 bust.”

In 2010, thanks to the shale plays and new Securities and Exchange Commission reserve-reporting rules that took effect in 2009, the U.S. is expected to increase its gas reserves by a whopping 45%.

Ben Schlesinger, partner and economist for Houston-based Galway Group LP (which acquired Benjamin Schlesinger and Associates in February 2009) says that shale gas is an “incredible” game-changer.

"Our proved reserves are now up to 7 trillion cubic meters, which is larger than Saudi Arabia, "says Ben Schlesinger, partner and economist for Houston-based Galway Group LP.

“Our proved gas reserves are now up to 7 trillion cubic meters, which is larger than Saudi Arabia,” he says. “Our potential resources, including the P-50 (50% likelihood) category, are now just slightly less than Russia’s. That’s not to say they don’t have shale as well, but they have not been exploring for it.”

The majors have hardly explored for shale at all, whether abroad or in the U.S. “The U.S. independents found it, and there is not really an independent class like ours in other countries. We can expect more shale gas to be found here because we have a good investment climate in this country.”

Gas prices

The continued wealth of shale gas bodes ill for gas prices, however, at least for the near term, says Smith. “Since the recession, the combination of weak demand and the sizable amount of excess supply has weakened the energy market. We had gas prices that dipped below $3 per thousand cubic feet (Mcf) in September. That’s off a high of about $14 two years ago.”

Price volatility has wreaked havoc on producers’ 2010 budgets and they are getting no help from analysts who can’t agree on price forecasts. Recently, Credit Suisse Securities (USA) LLC predicted a 2010 gas price as low as $4.70 per Mcf. Stephen Smith Energy Associates called for an average $5.50 per million Btu at Henry Hub in 2010. Tudor Pickering Holt & Co LLC believes gas will reach $7.50, while Sanford C. Bernstein Co. Inc. published its 2010 guess at a soaring $9 per Mcf. WoodMac predicts gas prices will drift around $7 in 2010 and 2011, and then escalate to $10 per Mcf by 2013.

Commenting on the highest price points, UH’s Smith asks, “How do they get that price? There are still shut-in gas wells because producers in some areas are refusing to sell gas at $3 per Mcf.”

But Smith notes that futures contracts for June 2010 are close to $6 per Mcf, although gas prices are usually lower in the summer. If that figure is reached, some shut-in wells will come online and drive the price back down.

“Also, the Middle East can send us liquefied natural gas (LNG) that costs them virtually nothing,” says Smith. “Because of that, natural gas prices are likely to remain weak for three more years.”

While the LNG threat is still being bandied about, there is another side to that coin, according to Schlesinger.

“North America is now self-sufficient in gas energy and is poised to go into the early part of the next decade meeting demand with only seasonal imports of LNG,” says the economist. “In fact, I’ve said publicly that we may be exporting LNG at some point in the future, and I still believe that. With U.S. gas as low as $5 and Europeans importing it at twice that amount, I think there will be exports of U.S. gas sometime in the future.”

Meanwhile, the continuing recession isn’t helping gas prices, says Karr Ingham of Ingham Economic Reporting, an economic analysis and research firm in Amarillo, Texas, specializing in the indexing and tracking of regional and metro economies. Ingham is also a member of the U.S. Association for Energy Economics.

“We haven’t had a recession this bad since 1991,” he says. “Since then, we have experienced a growing economy which has invariably led to growing energy demand. Simultaneously, we have seen burgeoning use of natural gas for power generation, which now accounts for close to 50%.

“But during the past two years of recession, when the demand for gas began to slow, production did not begin to fall immediately. In fact, it will probably be this year before we begin to see a significant (5% or more) fall in production.”

The economist notes that, in addition to less production, the U.S. needs to draw down the oversupply of storage gas. “We will also need significant economic recovery to drive increased demand before we have $6 gas for a sustained period of time,” says Ingham.

The third-quarter 2009 annualized gross domestic product (GDP) growth rate, about 3.5%, was a positive sign, despite the substantial contribution from bailout funds. But Ingham says he won’t celebrate until he sees “true economic growth” driven by the private sector, and not “this ridiculous amount of deficit spending that we are now amidst.”

Gas demand

A demand increase will come largely from industrial power generation, says Schlesinger.

“Virtually all new power plants in the last 15 years have been gas-fired. We have recently seen 300 gigawatts of new power capacity and there are plenty more on the drawing boards, so it has been meeting our growth demand in power gen,” he says.

Gas-fired power plants have distinct advantages over “just about everything else,” he says. “You can site them where you want relatively easily. Most people don’t object to them because they are small and clean. The capital cost is the lowest of any form of new electric generation. And they can be built quickly, some in as little as a year and a half.”

Schlesinger points out that, although detractors may point to historical gas-price volatility as a drawback, today’s hedging opportunities can remove much of the supply-contract risk.

“Gas trading is the second-largest futures market in the world, the largest being oil. About a trillion and a half dollars of gas ownership will be traded this year on the floor of Nymex. It is a highly liquid and widely available market.”

Detractors may trot out cap-and-trade or cap-and-tax issues as a threat to gas demand, but Ingham pushes back against those legislative initiatives.

“Political engineering of the economy and climate-change legislation, in the form of cap-and-trade, is not only disturbing, it is unpalatable,” he says. “It’s dangerous to start interfering with the natural functions of the marketplace.”

Cap-and-trade represents a “tremendous threat to the way we have economically operated our country during its entire existence,” he says, and contends that an era of higher prices for traditional energy products is not just an unfortunate by-product of that legislation. “It is the stated intention.”

Why is it, then, that when crude climbed to $150 per barrel, policymakers were “hauling in oil executives like they were criminals?” queries Ingham. “And those same people will create new legislation that will have the same effect? That’s just nonsense, and it worries me quite a lot.”

Transportation gas

Despite current challenges, the future of the natural gas industry looks bright. “I think the growth prospects for gas are really exciting, despite carbon rules,” says Schlesinger.

“There is a school of thought that says if the carbon rules are especially strong, there will be a large-enough growth in renewables to displace gas. But there are limits to solar and wind power and they are unpredictable. Gas demand is going to grow in the coming decades, not shrink. We can’t install renewables fast enough to displace gas from the energy mix.”

Karr Ingham, of Ingham Economic Reporting, advises legislators to "let the market run its own course," and is confident the market will choose gas over other fuels.

Ingham agrees, saying, “The environmental ‘anti’s’ don’t want to burn any fossil fuels, but I don’t know what they do want us to use to power our economy. On that side, the arguments are not grounded in common sense. When we set that aside and realize we are going to need something to run our transportation, logic once again supports using gas.”

Ingham advises legislators to “let the market run its own course,” and is confident the market will choose gas over other fuels.

“We have ample amounts here and access to imports from Canada that are less politically troublesome than Middle-Eastern imported crude oil. Right now in the U.S., gas makes up about 0.2% of transportation fuel, but we have to start somewhere.”

Schlesinger also promotes using gas for transportation. “I put my money where my mouth is. I have the only garage in Maryland where you can fill up a compressed natural gas car. The compressor cost about $3,500, and our gas-utility company was very instrumental in helping to install that system.”

Altogether, he has spent about seven years behind the wheel of a compressed gas vehicle, owning first a converted Mercedes and then a Chrysler, beginning in the 1990s. At the time, the cars were dual-fuel vehicles. Interestingly, the Mercedes conversion was undertaken in Canada for only about $2,000.

In the power sector, Schlesinger predicts that more coal-regasification power plants will replace coal-burning power-generation facilities in the new-build space.

That trend would also support the clean-fuel option to drive electric vehicles with power from gas-fired generation plants, says Schlesinger. “Electric cars can go three times farther on a foot of gas when it is converted to electricity as opposed to compressed gas. That’s got a real future.”

Finally, there is an option to use gas-based hydrogen as fuel. “The Honda Clarity FCX has a system that will take gas and convert it to hydrogen using a small reformer located at home. The waste energy could be used to produce hot water or home heating, which is a big deal in Maryland. I am hoping to put one of these systems in our home one of these days.”