By Marin Katusa, Chief Energy Investment Strategist

North America is undergoing a natural gas revolution. The first part of the story is pretty well known: the advent of horizontal drilling and fracturing technologies unlocked huge shale-gas reserves across the continent, and the ensuing flood of production cut the commodity’s price in half. In January 2011 the spot price of natural gas in the United States averaged $4.49 per million British thermal units (MMBtu). Today, the price is just $2.20 per MMBtu in the US, while in certain areas in Canada production is selling around C$1.80 per MMBtu.

Most of America’s gas producers simply cannot make money at that price. Companies are cutting back on output levels, but it will take at least a year before those cutbacks start to ease the country’s supply glut. And the glut is massive: there are currently 2.38 trillion cubic feet (TCF) of produced natural gas sitting in US stockpiles. That is 47% above the level at this time last year and 54% higher than the five-year average.

This part of the story has been covered at length in the mainstream media. Much less discussed is the path forward for natural gas. Sure, there are lots of general comments that the market will remain depressed for some time, but what does that really mean? And more importantly, how can an investor look to profit?

It’s a complicated scenario, so today we will go through just one aspect of America’s natural gas conundrum: looming reserve downgrades. Reserves are an estimate of the amount of gas in a reservoir that can be extracted economically, which means that reserve volumes depend on the price of gas. When the price falls by 50%, reserve volumes soon have to follow suit. These major reserve downgrades will send damaging ripples across an already delicate sector, creating both chaos and opportunity.

The ability to tap into shale-gas reservoirs created nothing less than a paradigm shift in the natural gas sector: the rules of the game changed and now all the players, consumers, and speculators are being forced to adjust. Energy-market evolutions like this demand nuanced investment responses based on multiple catalysts and forecasts, some of which receive endless attention, while others – like the looming downgrades – take almost everyone by surprise.

That “almost” does not include us. Natural gas is a complicated game right now, but if you want to play, we’ve got your back. (I’ll be revealing a host of hidden energy-sector plays – including specific companies that have outsized profit potential – at the upcoming Casey Research Recovery Reality Check Summit.)

Describing Size

Size matters, especially when it comes to resource deposits. Potential partners, offtake customers, and investors always want to know how many tons of coal, barrels of oil, ounces of gold, pounds of copper, or cubic feet of natural gas a project contains. However, the size of a resource alone is not enough.

The other key number is the reserve count – and not all resources are reserves.

“Resources” describe the amount of a commodity contained in a deposit. A geologist assesses the drilling results for an area and estimates the total amount of oil, gas, or gold in the ground at that site.

Just because a resource exists does not mean that it is technically or economically feasible to actually recover it. That’s why reserves are a subset of resources. First, geologic and technologic factors determine the resource recovery rate, which reduces the resource to the parts that are “technically recoverable.” Then economic considerations kick in, further reducing the resource to just the bits that are “economically recoverable.” The image below from the United States Geologic Survey illustrates this whittling-down process.

Of course, the full breakdown is much more detailed than that. To incorporate all of the factors that influence the economics of production, total reserves get broken down into several subsets:

Proven reserves: those reserves with a reasonable certainty (usually at least 90%) of being recoverable under existing economic and political conditions, with existing technology. These are also known as 1P Reserves.

• Proven developed reserves can be produced from existing wells or from additional reservoirs with minimal additional investment
• Proven undeveloped reserves require additional capital investment (i.e., new wells) to bring the oil or gas to the surface

Unproven reserves: those reserves with less certainty of being recoverable under current conditions because of technical, contractual, or regulatory uncertainties

• Unproven probable reserves carry a 50% confidence level of economic recovery. Adding these probable reserves to a project’s proven reserves gives the 2P Reserves
• Unproven possible reserves carry a 10% certainty of economic recovery. Adding these possible reserves to a project’s proven and probable reserves gives the 3P Reserves

The Economics of America’s Natural Gas Reserves

In valuations, it is a company’s 1P reserves that really matter. 2P reserves are also interesting, but companies are always trying to upgrade their 2P reserves to 1P status because investors, partners, and customers only really care about the oil or gas that carries a 90% certainty of being economically recoverable today.

The most important factor in calculating 1P reserves is commodity price. The netback a company will earn on each barrel of oil or cubic foot of natural gas starts with the realized sale price. If that price is too low, all the costs associated with producing the commodity will pull that netback into the red. Once that happens, the reserve is no longer a reserve because it ain’t economic.

Over the last decade, the price of natural gas averaged US$5.82 per MMBtu, which is three times its current level. A decade of high natural gas prices did two things. First, it encouraged massive exploration efforts, which were highly successful because of the debut of horizontal drilling and fracturing. Second, it ensured that great swaths of the resources delineated during that exploration mania were economic. The combination pushed US natural gas reserves way up.

(Click on image to enlarge)

At this point our headline is probably starting to make sense: natural gas reserve downgrades are coming. The price of natural gas has been cut in half. The correlation is not so direct as to allow us to say that reserves will now fall by half, but we have done calculations on many companies and have determined many will have to downgrade their natural gas reserves by 40%.

Few companies have publicly re-assessed their gas reserves using contemporary prices, so this concept has not yet hit the mainstream. A few analysts have run numbers on the gas producers they follow; 40% losses are standard. It only makes sense: far less natural gas is economic to produce at US$2.20 per MMBtu than at $6.

With every downturn comes an opportunity. With natural gas, the opportunity will be to pick up producers after these reserve downgrades depress their share prices. As always, the hard part will be knowing when they have hit bottom.

It’s a challenge I have embraced. With my analysts, I have developed an innovative computation that will let us see when a company reaches a valuation consistent with its re-assessed 1P reserves. Our models will warn us when one of the companies on our watch list (which includes companies that already passed through our other analytical wringers) reaches its new real valuation, priming us to watch for the moment to move.

Not every natural gas producer will survive the next 12 to 24 months. These looming reserve downgrades will shock an already depressed market, and companies without the financial stability to weather the storm will sink. Making matter worse, lots of gas producers hedge their output – and the juicy hedges that reflect out-of-date high prices will come undone later in the year.

The smart investor will anticipate reserve write-downs. When the market punishes the sector, buying opportunities for certain companies will arise. Companies that survive the next few grueling quarters will be rewarded with a natural gas resurgence. Stockpiles will fall, demand will rise, and prices will recover. It will not happen quickly, but it will happen… and when it does, we will be ready.

We have our list of companies to watch. Do you?

Additional Links and Reads

Marin Katusa Discusses Uranium (BNN)

Casey Research’s chief energy investment strategist outlines his uranium predictions. With a raft of new nuclear facilities under construction across the developing world and a series of shifts in global uranium production and processing on the horizon, Katusa sees a rising uranium spot price and a price premium for made-in-America uranium. How to benefit? He also names his top uranium stock picks.

If you would like to hear more from Marin and you will in Calgary this weekend, stop by the Cambridge House Calgary Energy & Resource Investment Conference where Marin is giving a keynote talk on this Friday and will participate in a panel talk on this Saturday.

Slow Reform Weighs on Nigerian Oil (The Globe and Mail)

Security is improving in Nigeria’s oil-rich Niger Delta, but now instead of militants and guns it is legislation – or a lack thereof – that is seriously slowing production growth in Africa’s largest producer. A new petroleum industry bill was drafted in 2008, but it is still not law; its passage has stalled and its terms are constantly being altered. As a result, oil majors including Shell, Chevron, and ExxonMobil have put billions of dollars of Nigerian oil investment on hold.

China Says Iran Imports Legal, Won’t Accept Unilateral Sanctions (Platts)

China’s foreign ministry insists its imports of Iranian oil are legal. In a recent report from state news agency Xinchua News, ministry spokesman Hong Lei blasted US sanctions against the Islamic Republic and said that China “opposes any country implementing unilateral sanctions on the other country according to its domestic law.” His comments came a day after Washington announced 180-day exemptions from the sanctions for Japan and 10 European countries, after those nations supposedly reduced their crude imports sufficiently.

Charges Filed Against Chevron, Transocean in Brazil (The Globe and Mail)

Federal prosecutors in Brazil filed criminal charges against 17 oil company executives over a 3,000-barrel oil leak in the Atlantic, a move that could well slow Brazil’s efforts to develop its massive offshore finds. The leak occurred in November and already led to a $11-billion civil lawsuit against the companies. Now the 17 company executives face the potential for prison terms, asset seizures, and significant fines. Brazil is working to become one of the world’s top oil producers after discovering offshore reserves holding 50 billion barrels of oil, but legal charges like this over a relatively small spill could well spook other big, foreign companies, leading to development delays. (We wrote about this situation in a late-December CDD.)

At Oklahoma Hub, Obama Pledges to Speed Part of Pipeline (Reuters)

President Obama pledged to accelerate approval for the southern leg of the Keystone XL pipeline, which will connect the oil hub at Cushing with refineries on the Gulf Coast. Project proponent TransCanada is still working to re-route the contentious northern leg of the pipeline around Nebraska’s sensitive Sandhills region, but there are no such concerns about the southern leg. Cushing is overflowing with oil because of production increases in the oil sands and the Bakken; the hub very much needs another pipeline connection to the Gulf Coast.

Natural Gas Pain Is Oil’s Gain as Frac Crews Head to North Dakota (Reuters)

Collapsing natural gas prices are lending a helping hand in North Dakota, where a shortage of fracking crews had tempered the biggest oil boom in a generation. Now, with natural gas prices in free fall, producers are cutting back on new exploration and production, leaving frac crews available to shift to oil wells in North Dakota’s Bakken play. The number of idle wells waiting to be fracked in North Dakota reached a record 908 last June.

Global Steel Output Shows Recovery Still Fragile (The Globe and Mail)

Global steel production rose slightly in February from a month earlier, but production is down somewhat compared to a year ago. The sector continues to generate a mixture of positive and negative data, prompting analysts to comment that while steel may be slowly getting back to its feet, the industry still has a ways to go to recover from the recession.

One more thing before we wrap up. A new Casey phyle is being organized in Long Island, New York. If you’re interested in getting together with a group of like-minded individuals in the area, please send us an e-mail at phyle@caseyresearch.com.