The Organization of Petroleum Exporting Countries (OPEC) has injected considerable volatility into the energy market since many of its members declared that they would voluntarily restrict production in an attempt to rebalance the global market, and along the way, raise crude prices.
The global price of crude has implications for U.S. natural gas production and prices, but the relationship is not well understood.
While natural gas prices exert little impact on the global price of crude, the global price of crude has a significant impact on natural gas production, thus the U.S. natural gas price. Depressed crude prices have contributed significantly to a leveling, and more recently, a decline in U.S. natural gas production. That decline now threatens to become a supply shortage that will lead to a sharp rise in natural gas prices over the next six months to a year. Ironically, OPEC’s success, while raising oil prices, may place a cap on rising natural gas prices, or possibly even drive them lower. This article explores this dynamic.
The total revenue that a producer receives and that drives return on investment, is a function of the price of each contributing commodity. Decisions to drill are predicated on expected revenues from the combination of commodities that the producer projects it will get from each well. In areas such as the Karnes trough in the Eagle Ford basin, crude volumes are so large relative to the comingled gas volumes that the price of gas is largely irrelevant to the decision to invest capital in the well; rather, it is the price of crude that drives revenues and drilling activity. In other places such as the Anadarko basin, crude production is a lower portion of overall revenues from the well, so the natural gas and/or natural gas liquid (NGL) production makes a material difference to the overall return of the well. In these areas, the combination of oil and gas prices are relevant to the investment decision, as depicted in Figure 1.
Figure 1: WTI and Henry Hub Price Sensitivity Charts, Top Tercile of Wells
Source: DI ProdCast. Charts show the sensitivity of different basin/fields to WTI and Henry Hub prices. Every point on the line corresponds to a WTI & Henry Hub price combination that provides a 20% minimum acceptable rate of return.
In Figure 1, the lines represent the combination of oil and gas prices that provide a 20% minimum acceptable rate of return from the top tercile of wells in various fields within the Permian and Anadarko basins. A steeper slope indicates greater sensitivity to gas prices, as gas comprises a larger proportion of the production stream. Therefore, the figure illustrates that Permian basin wells are less sensitive to gas prices than Anadarko basin wells are, because the relative proportion of gas supply is small relative to oil. However, because of comingled oil and gas production, it is critical to forecast the combined production stream – oil and gas – at various price combinations in order to accurately depict the economics of supply. In our example above, without understanding the gas oil relationship an analyst would be likely to underestimate gas production levels if either commodity price changes.
The significant of this point is illustrated by reviewing historical gas production from the past eight years. During the early phase of the shale revolution, drilling activity focused on natural gas wells. It triggered dramatic increases in gas production, from 48 Bcf/day to 62 Bcf/day from January 2007 to December 2011, a 28% increase over the period. Not surprisingly, the increase in production resulted in a decline in gas prices to below $2.00/MMBtu.
The significant of this point is illustrated by reviewing historical gas production from the past eight years. During the early phase of the shale revolution, drilling activity focused on natural gas wells. It triggered dramatic increases in gas production, from 48 Bcf/day to 62 Bcf/day from January 2007 to December 2011, a 28% increase over the period. Not surprisingly, the increase in production resulted in a decline in gas prices to below $2.00/MMBtu. What was surprising, however, was that despite low gas prices, gas production subsequently increased to a peak of 73.5 Bcf/day in February 2016, as shown in Figure 2 below.
Figure 2: Henry Hub Gas Prices versus U.S. Dry Gas Production, January 2005 – October 2016
Sources: DI ProdCast for gas production, EIA for prices.
Excerpted from Oil and Gas Investor April 2017 Copyright © • Hart Energy Publishing LLP
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