To an economist, a company that chooses to ramp up the production of its widgets when the price of widgets is falling is about as counterintuitive as an anti-gravity machine is to a physicist.

So what’s going on in the natural gas industry, where companies are openly violating a basic principle of supplyside economics? In many gas-rich areas of North America the number of rigs drilling is still rising while the price of natural gas continues to be falling. The net effect is predictable: US gas volumes are increasing and are now in line with last year’s rate of production. After adjusting for seasonal weather effects, momentum in the déjà vu data is now pointing to another oversupply situation by summer. It seems there is a whole group of corporate leaders that forgot to take Econ 101, who continue to is patch more and more rigs even though the price of natural gas is getting progressively weaker.

At least that’s the view from the Econ classroom. In the real and frenzied world of shale gas there are other gravity defying dynamics at play.
Over the past three-to-five years there has been a mad scramble by gas exploration companies to lease vast tracts of land in all the hot US plays thought to contain lucrative volumes of shale gas. As part of the Klondike wheeling and dealing, the companies that have staked claims are now contractually obliged to drill and produce wells on their newly-acquired lands by a set expiry date, lest they lose their leases. The obligatory choice stemming from this “drill it or lose it” dilemma goes a long way to explain why rigs that boost production keep being dispatched, even as the price of gas gets dragged down in the process.

Yet, drilling to preserve lease obligations is only notionally possible unless there is money available to drill. Bringing multi-million dollar shale gas wells to market requires tremendous capital resources. At below $US 4.00/MMBtu (where the price of gas closed last week at the benchmark Henry Hub) the ability to generate adequate cash flow at the corporate level, and recycle capital back into the ground to generate an acceptable return, is dubious for most companies. That’s why the ability of shale gas companies to ‘lock in’ or ‘hedge’ the future price of their production in the forward markets has also been a vital pillar of their keep drilling strategy.

For a couple of years now contango prices in the natural gas futures market has allowed producers to sell a good percentage of their future production between $6.00 and $7.00/MMBtu. It’s been an easy way for credit worthy companies to realize a 20-to-30 percent price premium to the prevailing market and it’s more than a sufficient price for shale gas companies to grow. Add to that the ability of these companies to raise capital through debt or equity, or through divesting old conventional properties, and it’s easy to see how there continues to be plenty of money to keep the drill bits turning even when current market prices weaken.

There is one other perspective to be taken. Like purveyors of any new and disruptive product, hard running shale gas companies are out to get market share first and foremost. The dominant strategy in this formative game is to grow as fast as possible, at any cost, taking no prisoners, until the jockeying for position is over. Only after the market has matured does the focus shift to respecting price and making money.

Putting all these factors together helps understand why companies in shale plays are so persistent in drilling for natural gas with little deference to current price. But the falling current price can be ignored for only so long and the game must eventually come to an end. In fact, one of the main drivers of the drilling frenzy, the ability to lock in lucrative futures prices has already cracked. At best, producers can now lock in only $US 5.50/MMBtu a year out. As price falls, investors are shying away from further capitalizing the space. And of course selling old assets to fuel more drilling is increasingly difficult in the deteriorating gas price environment. In short, capital for more drilling should start to dry up, though admittedly it could take many months of very low and uneconomical gas prices for the necessary drought to set in.

In the meantime, it’s easy for long time gas producers to lose belief in the eventual anti-gravity of prices when the gravity of incessant drilling and oversupply is pulling price down so strongly. Yet economics is not physics; the harder gravity pulls down natural gas prices, the greater the chance of an anti-gravity price machine.

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Peter Tertzakian, Chief Energy Economist

Kara Baynton, Manager, Energy Research

Disclaimer The information and data contained herein has been obtained or prepared from sources which ARC believes to be reliable but has not been independently verified. ARC makes no representations or warranties as to the accuracy or completeness of such information and data nor the conclusions derived therefrom. This document has been published on the basis that ARC shall not be responsible for, and ARC hereby expressly disclaims any responsibility for, any financial or other losses or damages of any nature whatsoever arising from or otherwise relating to any use of this document.