By Arthur Berman of OilPrice.com
Enthusiasts believe that shale gas is simultaneously cheap, abundant and profitable thus defying all rules of business and economics. That is magical thinking.
The recently released EIA Annual Energy Outlook 2016 sparkles with pixie dust as it forecasts almost unlimited gas supply at low prices out to 2040 and beyond. Exuberant press reports herald a new era of LNG exports that will change the geopolitical balance of the world and make America great again.
But U.S. shale gas production is declining because of low prices and shale gas companies are in deep financial trouble because in the real world, price and cost matter. That is not magical.
First Quarter 2016 Financial Performance
The financial performance of shale gas-weighted E&P companies in the first quarter of 2016 was a disaster.
Chesapeake Energy, the biggest shale gas producer in the world, had negative cash from operations. That means that oil and gas sales didn’t even cover operating costs much less capital expenditures like drilling and completion.
Other shale gas-weighted companies including Anadarko, Comstock and Petroquest also had negative cash from operations. Goodrich and Sandridge are in bankruptcy and Exco and Halcon will soon follow. Ultra, Forest, Quicksilver, Swift and Talisman were lost in action last year.
On average, surviving companies out-spent cash flow by two-to-one both in 2015 and 2016 but many normally strong companies greatly increased negative cash flow this year (Figure 1).
Figure 1. First quarter 2016 and full-year 2015 shale gas E&P company capex-to-cash flow ratios. Source: Google Finance and Labyrinth Consulting Services, Inc.
Devon Energy has been cash-flow neutral through much of the shale gas revolution but disturbingly increased capex-to-cash flow 5-fold in the first quarter of 2016. Similarly, Southwestern Energy has had an excellent record of near-cash flow neutrality but doubled its negative cash flow in 2016.
The debt side of first quarter earnings is far more disturbing. The average debt-to-cash flow ratio for shale gas companies increased almost 4-fold to more than 7, up from less than 2 in 2015 (Figure 2).
Figure 2. First quarter 2016 and full-year 2015 shale gas E&P company debt-to-cash flow ratios. Source: Google Finance and Labyrinth Consulting Services, Inc.
Devon’s debt-to-cash flow was more than 21 and Southwestern’s, more than 17. Gas prices below $3 cannot be sustained without damaging the balance sheets and income statements of even well-managed companies.
Debt-to-cash flow is a critical determinant of risk from a bank’s perspective because it measures how many years it would take to pay off debt if 100 percent of cash from operations were used for this purpose. This means that it would take these companies an average of 7 years to pay down their total debt using all cash from operating activities.
The energy industry average from 1992-2012 was 1.53 and 2.0 was a standard threshold for banks to call loans based on debt-covenant agreements. That threshold increased in recent years to about 4 but 7 years to pay off debt is clearly beyond reasonable bank exposure risk.
Low Gas Prices and Declining Production
Shale gas is the principal support for all U.S. gas production since conventional gas is in terminal decline. U.S. dry gas production has declined almost 1 Bcf per day since September 2015 largely because of low gas prices (Figure 3).
Figure 3. U.S. dry gas production and Henry Hub price. Source: EIA May 2016 STEO and Labyrinth Consulting Services, Inc.
Henry Hub gas prices have fallen for the last 2 years from more than $6/mmBtu in January 2014 to $2 today and prices have been below $3/mmBtu since early 2015. A similar gas-price decline occurred from June 2011 to April 2012 (Figure 3). Then, dry gas production fell when prices dropped below $3/mmBtu.
$3 is well below the break-even gas price for any operator in any play. Even in the Marcellus–the most commercially attractive shale gas play–break-even prices are more than $3 (Table 1).
Table 1. Marcellus break-even gas prices. COG: Cabot, CHK: Chesapeake. Source: Drilling Info and Labyrinth Consulting Services, Inc.
Shale gas production has fallen 0.83 Bcf/d since February 2016 (Figure 4).
Figure 4. Shale gas production. Source: EIA Natural Gas Weekly and Labyrinth Consulting Services, Inc.
All plays have declined from their respective peaks except the Utica Shale. Marcellus production accounts for more than a third (-0.36 Bcf/d) of shale gas decline in 2016. There is certainly no shortage of supply in that play but low prices and related delays in pipeline commitments have taken their toll on production.
There are no longer any horizontal rigs drilling in the Barnett or Fayetteville, plays that were supposed to help provide the U.S. with 100 years of gas supply. That is the intersection of magical thinking and low gas prices.
Higher Gas Prices Are Likely
Lower gas production along with increased consumption and exports spell higher gas prices later in 2016 and in 2017. Latest data from EIA corroborate the impending late 2016 supply deficit that I wrote about last month (Figure 5).
Figure 5. U.S. dry gas supply balance and forecast. Source: EIA May 2016 STEO and Labyrinth Consulting Services, Inc.
A supply deficit does not mean that there won’t be enough gas but will require more extensive withdrawals from inventory and that will move prices higher. During the last supply deficit in 2013 and through much of 2014, Henry Hub spot prices increased from $2 at the peak of the previous surplus to more than $6 per mmBtu and averaged $4.05.
Comparative inventory (C.I.) is determined by comparing current stocks with a moving average of stocks over the past 5 years. There is a strong negative correlation between C.I. and natural gas price (Figure 6).
Figure 6. Natural gas comparative inventory vs. Henry Hub price. Source: EIA and Labyrinth Consulting Services, Inc.
The same June 2011-April 2012 price decline shown in Figure 5 correlates with a strong increase in C.I. in Figure 6. In February 2012, C.I. turned around abruptly and prices responded quickly.
Similarly, the February 2014-March 2016 price decline in Figure 5 correlates with a C.I. increase in Figure 6. That build has slowed in recent weeks and C.I. will probably begin falling as production continues to flatten and decline.
During the period of C.I. surplus from October 2011-March 2013, gas prices averaged less than $3 just as they have during the present period of C.I. surplus since February 2015. I expect prices to move above $3 as the winter heating season begins. A possible temporary price drop in September would be consistent with previous periods when ample winter storage levels are reached after the U.S. Labor Day (J.M.Bodell, personal communication).
Shale Gas Magical Thinking: Price and Cost Matter
Shale gas made sense in the first decade of this century when real gas prices averaged almost $7/mmBtu (Figure 7). That was because there was a supply deficit as conventional production declined before shale gas supply increased to replace it.
Figure 7. CPI-adjusted U.S. natural gas prices, 1976-2016 (April 2016 U.S. dollars. Source: EIA, U.S. Department of Labor Statistics and Labyrinth Consulting Services, Inc.
Since 2009, however, prices have averaged only $3.81 and that is less than the break-even price for core areas of any play except the Marcellus (Table 2).
Table 2. Shale gas break-even gas price summary. Source: Drilling Info and Labyrinth Consulting Services, Inc
Shale gas enthusiasts have embraced point-forward economics that ignore many important non-capital costs of doing business. That is the difference between the break-even prices in Table 2 and lower estimates found in many analyst reports.
The EIA magically forecasts that shale gas production will increase from almost 40 Bcfd in 2016 to almost 70 Bcfd by 2030 at $5 (2015 dollars) gas prices; it will increase to almost 80 Bcfd by 2040 at prices below $5 per mmBtu.
The prices in Table 2 are for the core areas of the plays–much higher prices will be necessary to produce the marginal areas needed to support supply after core areas are fully developed. Although I respect EIA’s work and do not hold them to a very high standard on long-term forecasts, this view of the future of shale gas is not helpful.
Falling gas prices have exposed the delusion of shale gas magical thinking. Production growth was funded by debt. Capital in search of yield continued to flow and over-production pushed prices below $2 by the end of 2015.
The wreckage is clear from disastrous first quarter financial data and falling production. The Barnett and Fayetteville plays that were supposed to last 100 years are dead at current prices. The Haynesville will probably follow soon enough.
Capital may continue to flow to shale gas companies but most of it will be used to repair balance sheets. Prices will gradually increase and financially stronger companies with core positions in the Marcellus and Utica plays will survive. Many companies will not.
The U.S. has perhaps a decade of gas supply at about $6 and considerably more at higher prices. By the time prices reach those levels, the folly of export will be apparent.
