A Shale Tale: Natural Gas Will Pay the Price for Own Success

By Liam Denning

In this nascent age of shale, price rallies for natural gas tend to vanish into thin air. Is it different this time?

Despite slipping late last week, U.S. natural gas is one of the best-performing commodities this year, up 14%. At about $3.85 a million British thermal units, gas prices have roughly doubled since late April 2012, when they hit their lowest level in about a decade.

But futures indicate limited gains from here: Prices average about $4.22 for 2014 and don’t break above $5 until 2018.

A critical issue is at what point low gas prices cause U.S. supply to stop increasing. At the center of that debate is the Marcellus Shale basin. Stretching from Tennessee to New York, but centered in Pennsylvania and West Virginia, the Marcellus is forecast by Barclays to produce more than 10 billion cubic feet a day this year. That is about triple the level of only two years ago and would feed about one-seventh of U.S. gas demand.

Production growth rests on how many new wells are drilled, how productive they are, and how quickly output from existing wells declines.

Raoul LeBlanc, a partner at consultant PFC Energy, reckons the Marcellus is at or near an inflection point. Looking at Pennsylvania, he estimates the number of new wells drilled there fell by about a quarter in 2012. Meanwhile, many existing wells are at the point when high decline rates kick in after initially strong production. Combined, this suggests overall output should be flattening or declining.

That it has kept climbing reflects a backlog of older wells that were either not fully completed or awaiting pipeline links now being brought onstream, he says. He estimates there were about 870 such wells remaining in January, suggesting the backlog will be worked off this year. At that point, gas production in Pennsylvania will start declining, unless new drilling is encouraged by a higher gas price. Mr. LeBlanc sees gas hitting $5 by the start of 2014, four years ahead of what futures imply.

The broad parameters of that scenario make sense. Right now, with the oil price 23 times that of gas, against an energy-equivalence ratio of just six times, exploration-and-production investment dollars flow mostly toward oil.

Even so, getting to $5 in less than a year looks optimistic. For one thing, the exact size of the wells’ backlog isn’t clear: In March, Barclays put it at more than 1,400.

Marcellus wells also are low cost. In a survey published last year, Sanford C. Bernstein estimated about three-quarters of Marcellus reserves could be produced for less than $5 a million British thermal units. Even at today’s price, Marcellus-focused drillers such as Cabot Oil & Gas and EQT are almost able to fund drilling programs from internal cash flow, unusual for this sector.

Gas producers can do this, in part, by using futures to lock in prices and cash flow to pay for wells. According to Barclays, the number of rigs drilling gas wells in the Marcellus correlates closely with gas prices lagged by six months. Indeed, that rig count rose slightly in the first quarter, which fits well with the gas-price rally that gathered steam last summer and fall after the spring trough.

The Marcellus story tells investors that, in all likelihood, markets are past the low point in this gas-price cycle. That in itself is a major boon for gas-price bulls. Equally, though, the resulting increase in gas prices prompts the drilling that means $5 gas in early 2014 still looks like a stretch.

WSJ