"Vocal Minority vs. Silent Majority" by Bill Powers. FSO Editorial 04/08/2010

FSO Editorials

Vocal Minority vs. Silent Majority
by Bill Powers
Excerpt from Issue 11, originally published April 1, 2010
April 8, 2010

Rarely have I seen a time when such a large and vocal consensus of brokerage house analysts and Wall Street traders are convinced that natural gas prices will wallow below $6.00 for the next several years. As I write this on the morning of March 22nd, Macquarie Equities Research just put out a note predicting an average price for natural gas of $4.54US per million British Thermal Unit (MMBTU) for 2010, an average of $5.10US per MMBTU for 2011 and an average of $5.55US per MMBTU for 2012. On March 18th, the Lazard Capital Markets analyst cut his outlook for the average price of natural gas for 2010 from $6.00 to $5.00. I could go on but I think you get the point. The reason for the capitulation on gas prices by Wall Street analysts is nearly universal. Analysts believe that the recent bump up in the natural gas directed rig count, combined with drilling efficiency, will swamp the market with gas once again this year. Additionally, Wall Street traders are heavily betting that natural gas prices will continue on a downward trajectory. According to an article posted on Bloomberg’s website today, the U.S. Commodities Futures Trading Commission reported that, “hedge fund managers and other large speculators increased their net short positions, or bets that natural gas will fall to a record.”

As you might expect, I do not agree with the consensus view, and find the logic supporting the view that natural gas prices will continue their downtrend severely flawed.

The main reason for my contrarian opinion is that Wall Street analysts and traders are over-emphasizing the importance of horizontally drilled shale and vertical unconventional gas wells. They are completing ignoring the fact that conventional vertical production makes up the majority of production in North America. Currently, shale gas production makes up approximately 15% of US production and gas from vertical unconventional sources, such as coal bed methane (CBM) and tight sands, comprise another 20% of US natural gas production. Due to the rapidly maturing nature of many shale and unconventional vertical plays and their extremely steep decline curves, the pace of unconventional gas growth is set to slow markedly this year.

Not only does conventional vertical production account for 65% of US gas production, it also accounts for nearly all of Canada’s 13.5 billion cubic feet (bcf) of production. Vertical production from conventional basins should continue to decline at an accelerating rate due to a near complete lack of drilling. Falling Canadian exports, which are unlikely to be offset by increased LNG imports, will put further upward pressure on North American natural gas prices.

Based on the data I have been closely following, there appear to be only two shale areas that will show significant growth this year, the Marcellus and the Haynesville. In the Barnett Shale, production continues to decline after peaking in March 2009 at slightly more than 5 billion cubic feet per day (bcf/d) despite extensive use of pad drilling. (Source: Texas railroad Commission) Both the Woodford Shale and the Fayetteville Shale will show only modest growth this year despite pad drilling and longer length horizontals.

There are two main reasons the Barnett, Woodford and Fayetteville are either in decline or very close to it. First, the steep declines of the legacy wells make it difficult to offset these declines with new drilling. More technology equals steeper declines. Second, since the best areas of the Barnett, Fayetteville and Woodford were drilled first to hold leases and more recently to offset low gas prices last year, the quality of the reservoir in new drilling areas continues to decline. Even in the Piceance Basin (a tight sand gas field drilled vertically) where EnCana Corporation has developed what they refer to as a “gas manufacturing” operation with self-skidding rigs that can drill up to 52 wells from one pad, production growth has stalled. Despite the massive deployment of technology, the company will only be able to keep production flat with 2008 levels at 400 million cubic feet per day (mmcf/d). (Source: EnCana Corp.)

With the unconventional gas treadmill running at faster and faster rates, conventional vertical production declines are now overwhelming gas from shale and other unconventional basins. There is no better example of where this is happening than the State of Texas, the Big Enchilada. To put the importance of gas production from Texas into perspective, consider the following; Texas currently accounts for approximately one-third of US production and if it were a separate country (which some of its residents claim it to be), it would be the third largest producer in the world behind Russia and the rest of the US. (Source: EIA)

In 2009, Districts 1 and 9 were only two districts of the State’s 10 to show growth in natural gas production. District 9, which encompasses the majority of the Barnett Shale, will likely show a decline in natural gas production in 2010 due in large part to a drop in drilling activity. Another factor that will lead to declining production in the Barnett and one that few analysts recognize is that the quality of shale acreage is not created equally. The best parts of the Barnett have already been drilled. Most analysts use models assuming future results will replicate past results. Eight districts, including District 6, which is home to several unconventional Cotton Valley tight sand fields and a portion of the Hayneville Shale, showed production declines. Given that Texas showed a 3% decline in production in 2009 from 2008 (Source: Texas Railroad Commission) and with the majority of the State’s production coming from conventional vertical wells, I believe Texas is representative of the rest of the US production base.

Contrarian investors should look upon recent weakness in gas prices and the negative sentiment in the sector as an opportunity to purchase high-quality, gas-weighted companies at reasonable valuations. The Model Portfolio of the Powers Energy Investors contains several well-run, undervalued companies whose share prices should appreciate significantly when the inevitable rebound in gas prices arrives. Gas prices fell below $3 per thousand cubic feet (mcf) last fall before rebounding to over $6 per mcf during the winter months and I believe we are set up for an even more violent and longer lasting spike this summer once hurricane season arrives. Stay tuned.

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