Burgh Energy Report: Natural Gas Market

I'm trying to make sense of the low prices for natural gas but the increased drilling in the Marcellus Shale region. Understanding this is key for evaluating the prospects of Pittsburgh becoming the US energy hub. That is "the" energy hub, not "a" energy hub. Surprisingly, the competition for this distinction is Detroit and Chicago. I would have guessed Houston and Denver, maybe Charlotte (where Westinghouse almost ended up).

First, one has to look at the cost of production. On this score, the Marcellus Shale play is a perfect storm:

With the costs of drilling and labor shrinking as other companies pull back, it is cheaper to drill now than it was in 2007, when CHK first started its horizontal program here. The company has 17 drilling rigs in the play now and will more than double the number by 2011.

Why does this make sense? Even if the gas market continues to be unprofitable for many, the finding and drilling costs here for Chesapeake are wickedly cheap - in most cases, less than $1 for an MCF of gas that sells for $3 in the markets. And with the help of asset sales to partners like Statoil, those fall to 50 cents or less across some of the nearly 2 million acres of leases the companies share over the Marcellus.

More important, the Marcellus gas is closer to where the most folks in America use it - the East Coast. Natural gas is the heating fuel of choice for large population centers like Washington, D.C., and New York City. Less miles by pipeline means less expense in getting it to market and a higher price than you would get for the same gas if it were out west.

Throw on the preponderance of the chemical industry and oil refining in the east, and you have a healthy mix of customers for what's being pulled out of the ground by Chesapeake and a gaggle of others here.

This is why experts are so bullish on the Marcellus and resulting economic impact for states such as Pennsylvania. Furthermore, there would seem to be price increases on the horizon and natural gas drilling companies can expect bigger profits. Everything is pointing towards a big boom with Pittsburgh at the center of all the action.

The second factor to consider is the shift in drilling operations. Colorado is expecting jobs to move to Pennsylvania and Louisiana. Thus, some are calling for a reduction in regulation and taxes. That's something to track considering Pennsylvania's recent deliberations on the subject. There is going to be tremendous pressure on the Marcellus states to allow as much drilling as possible.

As far as I can ascertain (I'm not an energy analyst expert) natural gas supplies are in the midst of transitioning from conventional to unconventional because the price to extract shale gas is so much lower. According to the Calgary Herald, the result could be a short-term price spike:

The billion dollar question for 2010 is whether or not unconventional gas production in now-legendary plays like the Barnett, Haynesville, Fayetteville, Woodford, Marcellus and even Canada's Montney, to name a few, will be able to collectively respond fast enough to offset estimated conventional declines in 2010 of 5.0 Bcf/d in the US, plus another 1.0 Bcf/d in Canada. Theoretically it's possible, but nobody likes to talk theory at a party. Indeed, there are many practical constraints to boosting near term production including thin cash flows, stretched balance sheets, impatient bankers, tightened service industry capacity, and the strained logistics of mobilizing oilfield equipment once the price signals are convincing enough for E&P companies to spend money again.

In the long term, beyond 2010, shale gas and other large-scale unconventional gas plays will be increasingly dominant and able to offset conventional production declines. But that's the long term. Next year, it's quite possible that only half of the expected 6.0 Bcf/d of conventional losses in North America will be replenished. It's a scenario that speaks to benchmark continental prices rising above $US 6.00/MMBtu again, all else being equal.

This coming winter will be interesting. A mild combination of a colder-than-average temperatures, a gradual recovery in industrial demand and the gravitational pull of declining conventional production have a very good chance of collectively tightening up the oversupply that the natural gas industry has been living with for over a year. I give this near-term scenario at least even odds, and in part that's why natural gas prices have been rallying recently. After all, nobody wants to miss the party.

If the above scenario comes to pass, then you might imagine the scramble to drill that will engulf the Marcellus Shale region in just a few months time. Bump up the in-migration watch level to critical mass. Pittsburgh is the next Calgary. If you aren't sure what that means, consider a post I wrote about one-year ago about Alberta poaching frustrated H-1B talent here in the United States.