The Natural Gas Massacre

Natural gas is dirt cheap, hovering at a 10-year low. In the US, that is. In other parts of the world, natural gas is four, five times more expensive—a rare discrepancy in a globalized economy. In 2011, the US, the largest producer in the world, produced more natural gas than ever before. But, stunningly, there are no facilities to export significant quantities of it (as liquefied natural gas), though there are facilities to import it, which are now used for storage because imports have ground to a halt at the current price differentials.

The low price in the US has all sorts of beneficial consequences—and has become a cornerstone of President Obama’s energy policy. In the “Blueprint” released Monday, the White House touts its initiatives that encourage production and use of natural gas, particularly for transportation. It claims that developing the 100-year supply of shale gas that the US seems to have would “support 600,000 jobs by the end of the decade.”

But there is a problem: price. Natural gas is too cheap. And the low price, ironically, is throwing a monkey wrench into these plans.

The winter of 2010/2011 was harsh, and despite record natural gas production, high demand for gas as a heating fuel saw to it that storage levels fell well below the five-year average. This year, record production met a historically mild winter, and the normally steep draw-down of gas in storage has not occurred. Storage levels are 48% above the five-year average (EIA report). And prices, recently at around $2.28 per MMBtu, are less than half of the already low prices of last year. In fact, gas is so cheap that when it occurs as a byproduct in oil wells, it is often “flared,” that is burned off at the well, because installing the equipment to process and transport it is simply not worth it.

The drilling boom behind this bonanza was triggered by the confluence of advanced technologies in horizontal drilling and hydraulic fracturing that extracts gas trapped in rock deep underground. But fracking, as it’s called, has some issues:

– Drilling these wells is expensive, more expensive conventional wells.

– Gas production at these wells drops off sharply after a few months. After a year, it may be down 75%, and after 18 months, it may be down 90%. To increase production, more money must be invested. The well can be refracked, for example. It will revive it for a few months. But eventually, a new well will have to be drilled nearby, to start the cycle all over again.

A conventional well, after the one-time costs of drilling, produces a near constant flow of gas for many years, which allows the investor to recoup the original investment and make a profit over time. The principle is the same in fracking, but “over time” has a different meaning: months, instead of years. For this to appeal to investors, the price of gas must be high.

But it no longer appeals to investors, and drilling activity is collapsing. In 2008, the peak of the drilling bubble, there were at one point over 1,600 rigs drilling for natural gas in the US. During the financial crisis, the rig count fell off a cliff, then recovered a bit, but now is in free fall again. Last year at this time, there were 882 rigs drilling for gas. Two weeks ago, the count was down to 691. Last week it was down to 670 rigs (Baker Hughes).

Fracking has turned into a massacre for producers, and those that can are fleeing—to oil, a highly profitable activity. Others are contractually committed to drilling and producing gas, lest they risk losing their leases.

So these noble ideas of how dirt-cheap natural gas will perform miracles, as ballyhooed by the White House, will smack into reality: at current prices, drilling activity will continue to shrink while production at wells drilled over the last two years is plunging. At some point, the massive amount of gas in storage will be drawn down below a normal level. But production can’t be cranked up from one week to the next. Perceived or real shortages will drive up the price, but not to an equilibrium where producers barely break even and consumers enjoy low-cost energy. It will be a spike. We’ve been through this before.

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