Gas close to ignition

PORTFOLIO POINT: The dynamics of gas supply and demand point to a sharp rise in the benchmark gas price, and this will indirectly impact Australia’s LNG fortunes.

August is statistically one of the worst months of the year for natural gas prices, which makes sense given August represents high summer for the bulk of the world’s gas consumers.

On a technical basis, the analysts at Barclays are bearish on the gas price, seeing US$3.20/mmbtu as a price to get short.

This seems like a reasonable call, given the “gas price” price has been undergoing a substantial rally from the depths of an unseasonably warm US winter, even as the oil price has fallen. The benchmark global “gas price” is the US Henry Hub natural gas futures contract price.

But while the Henry Hub price might be a benchmark, it really only reflects the supply/demand balance in the US. Gas is not globally tradeable until converted to LNG, and LNG conversion is a very expensive proposition. Moreover, the Henry Hub price is a “spot” price while LNG trades under long-term export contracts. Those contracts typically price gas as a set ratio of the oil price, so the fact the Henry Hub price has only fallen since the GFC while oil has shot up is not fully reflected in contract pricing.

Realistically, the Henry Hub price is so far removed in nature from whatever price Australian gas producers can achieve for long-term LNG supply that the relationship is seemingly insignificant. But it’s not completely insignificant. It was not long ago that the US assumed it would not have enough natural gas resources to meet growing demand and began to build LNG inbound conversion plants for gas import. Then, in 2005, horizontal drilling was invented.

As is now well appreciated, this technique opened up access to vast shale oil-gas fields in the US Midwest previously assumed to be uncommercial. The race was on, and within six years America was staring at a gas glut. The Henry Hub price, which from hereon we’ll refer to as “the gas price”, peaked at US$13/mmbtu in mid-2008 and fell to US$3/mmbtu by mid-2009. The West Texas crude price hit US$147/bbl and then US$32/bbl in the same time frame. WTI has since been over US$100, but earlier this year gas hit an all-time low of US$1.89. There is your gas glut.

There have been other influences, including the particularly warm US summer this year and storage issues, but realistically while it previously looked like nothing could stand in the way of Australia dominating LNG sales to China into the future, the sudden rise of US shale has led to the development of LNG production and export facilities in the US, replacing planned import facilities. Australia’s sanctioned west coast offshore natural gas LNG and east coast coal seam gas LNG projects still have the jump on US shale LNG, but only by a year or two. The bottom line is that the US wants to join the competitive market for long-term gas supply to Asia, and on that basis the very low Henry Hub price, implicit of the glut, indirectly impacts on Australia’s potential LNG fortunes.

Gas price rally

Veteran energy players were shaking their heads in disbelief when the gas price traded under US$2 earlier this year. However we have since seen a steady rally – even as the oil price has fallen – such that this week the price has again returned to US$3. Here is where Barclays’ technical call kicks in, with a recommendation to sell at US$3.20 ahead of the traditional August demand crunch. However in an article published in Forbes magazine, contributor Richard Finger puts the case as to why a bearish view may prove unfortunate.

In short, Finger believes the natgas price will hit US$8/mmbtu by the northern winter.

Last week’s US Energy Information Agency (EIA) gas storage numbers showed a 28 billion cubic feet (bcf) injection. To put this into context, the same week last year saw a 67bcf injection and the five-year average is 74bcf. Last week marked the eleventh week of below-average storage injections. Total storage levels are now 19.2% above last year but only 17.5% above the five-year average. The total in May was 50% above the average.

US gas production increased by 30% from 2005 to 2011, but demand only increased 15%. In the summer of 2008 there were 1,600 rigs in operation. Then the gas price peaked. It fell steadily from US$13 to US$2 as the cost of production – of any resource sector operation – surged. In June this year there were only 486 rigs in operation.

Having failed at adding a major potash producer acquisition to its tier-one-projects-for-the-future collection last year, analysts expected BHP Billiton to divert its riches to expanding its Gulf oil portfolio as the alternative. Instead, BHP joined the US Big Oil majors and invested heavily in US shale gas. Australian analysts are now wondering just by how much BHP will have to write down that acquisition. Rising costs in the face of a weak gas price have forced BHP and its peers to shut down “dry gas” rigs and instead concentrate on more lucrative liquid shale oil extraction. Quite simply, the gas price does not justify the cost of start-up shale gas production at present.

In the past few years US gas production has risen to outstrip demand, so prices have fallen. Falling prices have since forced a reduction in supply, but what of the demand side?

Rising gas demand

One reason the Henry Hub price has bounced recently is because a hotter than average summer has followed a hotter than average winter in the US. However with the oil price still high, the gas price historically low, and coal always under threat of being hit hard by carbon pricing, that cheap oil price has proven too much of an incentive for power producers and energy consumers.

Aside from publishing storage figures, last week’s EIA report also noted a US milestone. For the first time in history, natural gas-fired power plants generated more electricity than coal plants. Each now produces just under a third of US power. There are also nuclear reactors still down for safety checks, only serving to add to gas demand.

It’s beginning to look like the BHPs of the world may have been a bit hasty in shutting down shale gas rigs, and maybe BHP’s big acquisition will yet prove a boon. But shale gas extraction is costly, and at some point the gas producer must make the price-sensitive commercial decision to continue or to abandon. The technique of horizontal drilling is only new, so no one is quite sure just how much shale gas there might really be to extract, either naturally or via compressors. Initial estimates have assumed a 25-year US production life.

Recent data suggest this assumption may be a long way off the mark. Shale gas wells appear to be declining at a much faster rate than anticipated. The novelty of horizontal drilling means everything from here involves a lot of guesswork, but to quote Richard Finger, “If the ‘tail’ in these wells fizzles out and the well becomes uneconomic after eight or even 12 years instead of the projected 25-year life then the entire economics of the shale boom must be revisited”.

All of the above is a summary of Finger’s argument as to why the bounce in the gas price from under US$2 to over US$3 (and bear in mind that’s 50%) is probably not representative of a good time to sell. And he throws in another, simplistic, point. Using an energy parity measure between crude oil and gas, a US$3/mmbtu gas price suggests WTI oil should be trading at US$18/bbl. But it’s trading at US$88/bbl. Which is wrong?

Neither are wrong of course, it’s the relativity that is wrong. So either oil must fall to meet gas or gas must rise to meet oil, or at least the two must converge at some point. Finger is backing a rise in the price of gas, and a sudden one at that once the penny drops. Hence his call for US$8 gas by the northern winter.

Even if the BHPs of the world rapidly switch their dry gas rigs on once again as the price rises, the implication here is that US demand is now on the rise. The above argument, if accurate, points to higher Henry Hub gas prices. Higher Henry Hub gas prices, as suggested earlier, will indirectly impact on the price Australian gas producers can achieve for their LNG (and in some cases new project viability). Higher prices will also support America’s LNG export intentions, so it’s a double-edged sword, with first-to-market bragging rights becoming ever more important.

Greg Peel is a journalist forFNArena, an online news and analysis service.

Readers should note all names are mentioned for educational and informational purposes only. Investors should always consult with a licensed professional before making investment decisions.