(John Kemp is a Reuters market analyst. The views expressed are
By John Kemp
LONDON, April 12 The recent rise in U.S. natural
gas prices, if sustained, will provide an opportunity to
identify the threshold that drillers need to cover their
marginal costs, the closest thing to conducting a controlled
experiment possible in real-time markets.
Concerns about peaking oil and gas production are over, but
the question about peak prices is still very much alive. The
shale revolution has ensured there will be sufficient oil and
gas but left unanswered the more important question about what
price will be needed to make sure they are available.
Relatively rapid decline rates on shale wells mean
production companies have to keep up an intensive pace of
drilling to replace declining output from existing wells, let
alone produce net new supplies.
However, forecasters and producers are still struggling to
identify the long-term marginal cost of shale oil and gas, which
is likely to set the long-term floor for petroleum prices.
It is clear that U.S. domestic gas prices have been
below their sustainable level, while oil prices are above
it, but the exact level of floor prices for gas and oil remains
Chart 1: link.reuters.com/nyt37t
Chart 2: link.reuters.com/qyt37t
Chart 3: link.reuters.com/syt37t
The number of rigs drilling for gas has fallen more than
three-quarters since August 2008 from around 1,600 to just 375,
while the number drilling for oil has tripled to more than 1,350
In 2008, four times as many rigs were being directed at
gas-rich rock formations than at oil-bearing ones. By 2013 the
situation had been reversed, and there were almost four times as
many rigs drilling for crude.
The sharp slowdown in gas drilling appears to have halted
the relentless rise in production, even allowing for a big jump
in associated gas output from oil wells.
Dry gas production has shown smaller year-over-year gains
since March last year, and in January 2013 it actually fell
compared with the same period a year earlier. It was the first
year-on-year decline since March 2010.
Meanwhile, oil output jumped 815,000 barrels per day (bpd)
last year, the biggest annual jump on record, and will rise
another 830,000 bpd in 2013 and 570,000 bpd in 2014, according
to the Energy Information Administration (EIA). Rising oil
output is far outstripping domestic demand growth. In fact,
demand is currently falling because of ethanol blending and more
stringent vehicle efficiency standards.
So from the supply side it is clear oil prices must fall and
gas prices rise to give drillers an incentive to shift at least
some rigs back from drilling oil and liquids-directed wells to
dry gas plays.
From the demand side, too, there is pressure for a
re-alignment to push prices closer to parity on an
energy-equivalent basis. At present, oil is more than six times
as expensive. Unless the gap shows signs of narrowing, oil will
lose substantial market share to natural gas in sectors such as
transportation and heating fuel.
The first part of this re-alignment may get underway later
this year as gas prices rise to curb some of the rapid rise in
gas-burning by power producers and incentivise exploration and
production companies to turn their attention back to developing
more gas supplies.
Spot gas prices have already doubled over the last 12 months
from a low of under $2 per million British thermal units to more
than $4. Most analysts put the long-term sustainable price floor
somewhere between $4 and $6 based on marginal costs.
As prices rise relative to oil, it should reveal more about
the price that producers need to resume capital expenditure on
gas drilling programmes and help identify the lower threshold
for sustainable prices in the long run.
NOT SO EASY
In practice, identifying threshold prices will be
On the supply side, most wells produce a mix of crude,
natural gas liquids and dry natural gas in varying proportions.
The large number of oil wells now being drilled are producing
substantial volumes of associated gas as a byproduct. Most gas
wells produce some liquids, and drillers have recently been
targeting the most liquids-rich gas formations to help offset
low dry gas prices.
Drilling has also become much more efficient over the past
three to four years, with rigs able to drill deeper wells with
longer horizontal sections in less time. The result is that the
same number of rigs can now drill far more wells than before.
The reduction in gas-directed drilling rigs overstates the
slowdown in new gas production.
Far fewer rigs are likely to be needed now to maintain and
increase gas output than in 2008, so the market may need to
shift only a few hundred rigs back to gas drilling.
Finally, on the demand side, record quantities of cheap gas
have been burned by power producers in preference to coal. As
gas prices rise, the fuel is likely to give back some of its
market share, which will help rebalance the market, even without
an increase in drilling.
Drilling may not react immediately to price increases. Many
production companies are likely to wait and see whether higher
prices are sustained before committing to more expensive
drilling programmes. Given the legacy of corporate debt carried
over from the earlier drilling boom, many firms also may focus
on using cash flow to reduce their leverage first.
Nonetheless, analysts and producers themselves will be
keenly watching for signs of a resumption in gas drilling and
what prices are needed to move the rigs back onto dry gas plays.
(editing by Jane Baird)