Increased production of natural gas from shale wells, combined with decreased consumption due to a warm winter are leading to a supply demand imbalance and very low prices in the United States. With current spot and future prices below the cost of production, some companies are in trouble.
The problem is explained in the Jan 23 article Natural Gas Picture Still Bleak:
A supply glut pressured natural gas futures for most of 2011, as production … remained robust, thereby overwhelming demand. … natural gas prices have dropped approximately 50% from 2011 peak …
… mild winter weather … has curbed natural gas demand for heating, indicating a grossly oversupplied market that continues to pressure commodity prices in the backdrop of sustained strong production.
and the fallout is seen the same day in Natural gas glut, low prices, prompt Chesapeake to cut exploration and production
Faced with decade-low natural gas prices that have made some drilling operations unprofitable, Chesapeake Energy Corp. says it will drastically cut drilling and production of the fuel in the U.S.
Drilling a natural gas well takes time, typically from 3-6 months from spudding until completion. When drilling begins, companies have an estimate of what it will cost to complete a well. If they hire talented geologists, they may have a reasonable guess as to what amount of natural gas they hope to find. What they don’t know is what price that natural gas will command 1-2 years down the road. For this they have two options: 1) gamble that the price in a year will be high enough to generate a profit; or 2) hedge by selling forward production on the futures market.
There is always a market today for natural gas that is to be delivered in the future. (Henry Hub natural gas futures). The sellers of these ‘futures’ contracts are the natural gas producers who want to guarantee a minimum price. The buyers of these futures contracts are typically large consumers of natural gas like power plants who want guarantee a maximum price. It’s basically the same thing as buying a season’s worth of heating oil at a fixed price the summer before the winter heating season.
We can do a little time traveling by looking at what the futures contracts for natural gas were two years ago when the now 1-year-old producing wells were penciled out on corporate balance sheets. A ‘futures chain’ simply connects the futures contracts for one month out, two months out, etc. to form a continuous chain when plotted. Figure 1) shows the futures chain for natural gas from January, 2010. This futures chain has a seasonal cycle which shows that natural gas prices are generally expected to go up for the winter heating season and then down in the spring. Figure 1) also shows what was expected at that time to be a generally increasing price trend.
Figure 1) Natural Gas futures chain from Jan 23, 2010.
On January 23, 2010, natural gas for delivery in February of 2012 could have been hedged (sold forward) at ~ $7/mmbtu and would have generated a tidy profit if well completion costs ended up in the $4/mmbtu range.
Things look a little different now:
Figure 2) Natural gas futures chain from January 22, 2012
Last Friday’s contract for delivery of natural gas next month went for under $2.50/mmbtu. Ouch!
Today, if companies hedge 100% of their production two years out, they will get less than $4/mmbtu in February 2014 which in some plays is below the cost of production. Chesapeake’s action belies this fact. They cannot profitably hedge and are apparently unwilling to gamble on an increase in prices.
You can blame it on a warm winter or on surprisingly robust production from shale plays but the fact is that production has outpaced consumption and we are about to move from shale gas boom to shale gas bust until production and consumption get back in sync at prices above, say, $6/mmbtu.
This will force natural gas producers to scale back on drilling as long as prices are in the $2-$4 range — prices no producers thought they would be seeing.
(Charts from the Market Futures databrowser)