Oil and Fuel: Cognitive dissonance and natural gas markets—low prices now, but what next?

it’s natural to become more confident and comfortable upon making a real-world observation that resonates with some theory or hypothesis that you hold. This is especially true, at least for me, when it comes to markets.

The term “cognitive dissonance” describes the opposite effect. Cognitive dissonance describes the mental stress and discomfort experienced by an individual who is confronted with two true, but apparently contradictory observations. In analyzing oil and gas markets, I am constantly put in the uncomfortable state of cognitive dissonance, and this feeling pushes me to look deeper to find the source of the discord.

The recent plunge in natural gas spot and front month future prices—from around $4.50 per million BTU (mmBTU) in mid-June to approximately $3.75 per mmBTU in mid-July—does not jive with the amount of natural gas in storage, our buffer against unpredictable winter demand. Storage now stands at a level which is 20 percent below the previous five-year low and more than 25 percent below the five-year average low experienced at this point in the build-up season.

So, what gives? Why are traders pushing natural gas prices down when the volume of natural gas in storage is at historical lows? 

The answer is simple. Weekly net additions to storage have been running at record and near record rates. Over the last 11 weeks, net additions set new highs on seven occasions, and on the four occasions that new highs were not reached additions were 20 percent above average. In other words, for the last three months, the growth rate of storage volumes has sent a signal to traders that there’s a high likelihood that storage levels will be very close to the historical norm by the beginning of the winter draw-down season.

While this explanation brings harmony to one case of cognitive dissonance, it brings about another altogether. How is it that net additions are growing at such a pace when drilling rates remain at levels that are so low?

According to Baker Hughes data, the number of natural gas drilling rigs in operation has declined 80 percent since the peak hit on September 12, 2008. More importantly, the number of active rigs drilling for natural gas is down 14 percent over last year’s levels. Considering that throughout 2013 the amount of natural gas in storage fell from glut-levels to the lowest level since 2003, the decline in the number of drilling rigs certainly doesn’t resonate with record weekly net additions and a 17 percent price decline.

The three-part explanation is straightforward. First, an increasing share of natural gas production is coming from what are considered by Baker Hughes to be oil wells. Indeed, it is a rare well that does not produce both liquid and gaseous hydrocarbons. So, as domestic oil production continues to surge, so too does the production of “associated gas.”

Not all of this gas is captured and brought to market, though. In places like the Bakken, many new wells are too far from existing natural gas processing plants and pipelines—consequently the associated gas is flared at the wellhead. Approximately 30 percent of the gas produced in the Bakken is flared today, but new legislation has been enacted that aims to reduce this waste.

Second, and more importantly, gas producers are becoming ever more efficient. This is due in part to their choice of well sites and in part due to technological advances. The length of lateral wells is increasing, thus each well is becoming more productive.

Productivity gains over the previous nine months—as measured in monthly additions from the average drilling rig—are impressive, ranging from 7 percent in the Haynesville formation to 72 percent in the Permian Basin. In the most prolific gas producing shale play, the Marcellus, productivity gains are up 13 percent.

The third driver of rising natural gas storage volumes is the weather. This summer, a “polar vortex” of sorts caused natural gas demand to be much lower than normal. What the January polar vortex taketh, the July polar vortex returneth.

For the time being, sense can be made of the low and falling natural gas prices. If net additions to the quantity of natural gas in storage continue along as they have been, underground storage should rise to a comfortable level before the next draw-down season commences at the end of the year. Of course, there is still plenty of time left for a heat wave or two to bring down net additions to storage.

So, while the recent price decline can be explained, the long-term challenge remains. At some point, as average annual demand for the commodity continues to increase and as LNG export facilities are brought online, demand will at some point break through the critical value, and drilling rates will need to rise. I suspect that this will happen sooner than later as a consequence of ever-increasing legacy decline rates.

Legacy wells are older wells that are in decline. Due to the nature of hydraulic fracturing, fracked wells have short lifespans and steep decline curves. Consequently, some number of new wells must be drilled just to maintain flat production, and that number is growing rapidly.
By way of example, legacy production declines in the Marcellus amounted to 171 million cubic feet per day in October 2013. By July, legacy declines had more than doubled to 395 million cubic feet.

A similar trend is occurring in the Eagle Ford and Permian basins. Legacy declines are declining significantly in only the Haynesville. Overall, though, accelerating legacy declines present a clear and present threat to net production. Enjoy the low prices while you can, because they too will come to an end.