In an October 8, 2012, research note titled, US Natural Gas Price Recovery – Is This For Real?, Wunderlich Securities Equity Research Analyst Jason Wangler covers the sustainability of current natural gas prices, and reports findings from an informal poll of producers for their thoughts on the natural gas markets.
Wangler says most producers are cautiously optimistic about the current uptick in natural gas prices. “Producers are generally not bullish, believing that gas prices would be range bound between $3.50/mmbtu and $4.00/mmbtu,” Wangler says. “In general, the industry is not eager to increase gas drilling unless gas prices reach $4.50-$5.50/mmbtu on a sustainable basis.”
Click here for a natural gas storage graph with five year averages.
OAG360 Comments:
After reading today’s research note, OAG360 wanted to look at two different scenarios:
- Part 1: Which company operations benefit from range bound prices between $3.50 and $4.00 per MMBtu?
- Part 2: Where we would expect to see increased natural gas drilling activity if prices were to consistently trade in the $4.50 to $5.50 per MMBtu range.
Part 1:
No rocket science here, but if prices were range bound between $3.50 and $4.00 per MMBtu, we would expect companies with mildly economic operations in natural gas plays to slowly add rigs – but there’s a catch. At these price levels, we believe only small amounts of capital would be reallocated from a company’s oil/liquids related drilling activities within a company’s operational profile. Remember, the E&P business is capital intensive. Without an unlimited budget, companies must make choices on how to allocate budgets among its asset base. If E&P companies are looking to pick up gas drilling again, they would need to increase their capital budgets which can be done a few different ways (the first two would be less favorable given only a small uptick in prices):
- Take on debt;
- Issue equity; or
- Reinvest incremental cash flow.
EnerCom, Inc. went back through its database to determine 2008 breakeven prices (10% rate of return) based on EnerCom’s decline curve analysis of the Woodford, Fayetteville, Haynesville and Marcellus Shales. We found the Woodford, Fayetteville, Haynesville and Marcellus shales had respective breakeven points of $6.45 per Mcf, $5.39 per Mcf, $3.62 per Mcf and $3.42 per Mcf based on the data collected in 2008. Fast forward to 2012 and companies operating in the Woodford, Fayetteville, Haynesville and Marcellus regions have improved their operations to reduce the disparity between the 2008 numbers above and today’s breakeven points of $3.93 per Mcf, $4.19 per Mcf, $3.51 per Mcf, and $2.88 per Mcf, respectively.
As you can see from the chart, the Marcellus has the lowest breakeven point therefore we believe certain companies could begin shifting capital to the Marcellus at these prices. Below are a few names that could benefit in a minor uptick in natural gas prices.
- Magnum Hunter Resources (MHR): During 2012, MHR only allocated 8% of its total $325 million CAPEX budget toward its Marcellus operations. That is expected to change during 2013 when the company’s MarkWest processing facility comes online providing MHR an additional $1.00 to $1.50 per Mcfe uplift on its natural gas price. Assuming a realized oil price of $90.00 per barrel and realized NGL price of $40.50 per barrel, a $6.5 million Marcellus well with an EUR of 9.2 Bcfe per well yields approximately 48% to 56% IRRs at a $3.50 to $4.00 per MMBtu natural gas price. OAG360 notes that both oil prices and NGL prices are trading below MHR’s inputs; however, given MHR’s expected $1.00 to $1.50 per Mcfe uplift from the processing facility, we believe the Marcellus becomes profitable enough to shift small amounts of capital from its other areas of operations.
- PDC Energy (PDCE): Despite the tremendous growth in the oil and liquids plays (horizontal Niobrara), approximately 66% of PDCE’s 2011 proved reserves were natural gas. The most notable effect range bound prices between $3.50 and $4.00 per MMBtu would have on the company would be in the Marcellus. Wangler says in his report: “With gas prices at current levels, PDC Energy can generate 25% return from its dry gas wells in Harrison County in West Virginia.”
- Equal Energy Ltd (EQU): Not a Marcellus player; however, just last week, EQU reported selling its remaining interests in the Mississippi Lime to concentrate its efforts on the Hunton play in Oklahoma. In a low case scenario, at $1.00 per MMBtu and $90.00 per barrel oil, the company generates a 10% IRR (breakeven price) on its Hunton projects. The Hunton is attractive at current prices; however, any upward movement in natural gas prices would have a significant impact on the company’s rate of return.
Part Two:
A $4.50 to $5.50 per MMBtu natural gas price range could have sweeping effects across the industry. First and foremost, we believe E&P operators would lock in long-term hedges (one to two years) hedges at these levels. By locking in these instruments, E&P operators ensure a minimum gas price to protect themselves from immediately having to switch gears again if the group drills itself back to $3.00 per MMBtu levels. OAG360 notes that if companies are able to lock in prices and ramp up drilling, we could see the spot and near term futures prices suffer as operators will drill to meet their hedge requirements.
It’s also important to note that given a $4.50 to $5.50 per MMBtu natural gas environment, companies with natural gas behind pipe, or shut-in wells could be turned on to sales.
Just a few examples of reported shut-ins/production behind pipe:
- Progress Energy Resources Corp. (acquired by PETRONAS): On June 14, 2012, the company was reporting approximately 10% to 15% of its production was current shut-in due to natural gas prices.
- Magnum Hunter Resources: In September 2012, MHR said it shut in approximately 400 natural gas wells in Kentucky in the current quarter due to reduced natural gas prices and higher transportation costs. In addition, the company has approximately seven gross (five net) wells awaiting completion due to the procession facility expected to come on line in November.
- Encana (ECA): During February 2012, ECA said it is immediately taking action to slow down or shut in production from existing well bores equaling an additional 250 MMcf/d.
Companies with large HBP acreage in the Haynesville, Barnett, Marcellus, and other gas plays could increase CAPEX budgets to take advantage of current pricing. The uplift in prices would make many plays economic. However, in order to reallocate capital to gas assets, a few things are needed.
First, IRRs must be superior to other potential plays that companies are considering investment. Even with WTI trading at nearly 28x Henry Hub, well above the 6x energy equivalent, current U.S. natural gas plays are generally more productive than oil plays which helps economics. For example, take a $9.8 million Bakken well with an EUR of 600 MBOE (3,600 MMcfe) and compare it to a $9.2MM Haynesville well that has a an EUR of 8,700 MMcfe (1,450 MBOE). The Haynesville well is approximately 2.5x more productive and comparable in D&C costs.
That said, we believe additional demand drivers need to be implemented in the U.S. or we will continue to drill ourselves into lower natural gas prices. Last but not least, services must be available. Many rigs have been moved out of gas plays. Companies will most likely have to pay rig mobilization fees to get them to move back which would in turn increase costs. Companies that own their own rigs could be first movers.
It is inevitable the industry would drill its way back to $3.00 per MMBtu given the opportunity with a $4.50 to $5.50 per MMBtu gas price unless greater demand forces are created (coal-to-gas switching, LNG, transportation). Many companies with large HBP positions in some of the larger natural gas plays like the Haynesville, Barnett, Fayetteville, Piceance, and Marcellus and have not fully transitioned their asset base to oil and liquids would lead the charge.
In this scenario ($4.50 to $5.50 per MMBtu sustained natural gas price), here are a few companies that stand to significantly benefit.
- GMX Resources (GMXR): The company sold its Cotton Valley assets in East Texas to reduce debt and fund its oil drilling projects in the Bakken. OAG360 points out that in its recent investment presentation GMXR needs a $5.00 per MMBtu price to begin drilling its Haynesville/Bossier assets in East Texas. GMXR has 163 net locations in East Texas targeting the Haynesville/Bossier. The company estimates 8.7 Bcf EURs translating to 1.1 Tcf of resource potential. A $5.00 per MMBtu gas price could have a huge impact on GMXR’s portfolio.
- Penn Virginia (PVA): Following the sale of its reserves and production in West Virginia, Virginia and Kentucky in July 2012 for $100 million, PVA’s operations in the northeast became focused on exploring the Marcellus Shale in Pennsylvania. As of December 31, 2011, PVA had an estimated drilling inventory of approximately 230 horizontal locations on approximately 35,000 net acres in Potter and Tioga Counties, Pennsylvania and approximately 17,000 net acres in southwestern Pennsylvania. Reaching way back to a June 2011 investment presentation, PVA reports its core Marcellus wells (4.2 Bcfe EURs and $4.5 million well costs) generate a breakeven return (10% IRR) at $3.62 per MMBtu gas prices. Needless to say, PVA’s core Marcellus wells become extremely profitable with a $4.50 to $5.50 gas price. OAG360 notes that on October 8, 2012, PVA announced its plans to issue 12 million shares of its common stock. A bullish sentiment on natural gas prices? Maybe.
Conclusion:
We’re not holding our breath for $4.50 to $5.50 per MMBtu gas in the near-term; however, sustained levels between $3.50 to $4.00 per MMBtu opens up projects for many producers but not enough for E&P companies to drastically switch their CAPEX budget weighting from oil to gas. If prices hit the $4.50 to $5.50 per MMBtu range, and companies are able to lock in hedges, we believe we could witness a large transition to natural gas plays.
Important disclosures: The information provided herein is believed to be reliable; however, EnerCom, Inc. makes no representation or warranty as to its completeness or accuracy. EnerCom’s conclusions are based upon information gathered from sources deemed to be reliable. This note is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument of any company mentioned in this note. This note was prepared for general circulation and does not provide investment recommendations specific to individual investors. All readers of the note must make their own investment decisions based upon their specific investment objectives and financial situation utilizing their own financial advisors as they deem necessary. Investors should consider a company’s entire financial and operational structure in making any investment decisions. Past performance of any company discussed in this note should not be taken as an indication or guarantee of future results. EnerCom is a multi-disciplined management consulting services firm that regularly intends to seek business, or currently may be undertaking business, with companies covered on Oil & Gas 360®, and thereby seeks to receive compensation from these companies for its services. In addition, EnerCom, or its principals or employees, may have an economic interest in any of these companies. As a result, readers of EnerCom’s Oil & Gas 360® should be aware that the firm may have a conflict of interest that could affect the objectivity of this note. The company or companies covered in this note did not review the note prior to publication.
