Dave's Energy

Monday, November 06, 2006

Natural gas prices: Why $7 is the new $3

Natural gas prices have been volatile, and there are no end to the different opinions you can get as to the future of gas prices. I get asked about gas prices quite a bit and over the last couple of years I have often stated that I believe $7 per mcf is the price at which we can see meaningful exploration and development of gas - enough to at least offset the significant decline rate of the average natural gas well in the U.S. This $7 view isn't anything earth-shattering, and is a view shared by many in the industry, but that isn't why we believe it to be true. It is based simply on the economics of drilling for natural gas in the somewhat mature basins of North America.

Let me start with the simple example I've shared over the years, an example from the "old days" of oil and gas (pre-2000). I'm simplifying here, but back then, if you were a producer that could find an MCF for $1, produce it for $1 and sell it for $3, you'd be pretty happy. This mathematical model allowed for growth in reserves and production and a positive return on capital. First you should recall that an oil and gas company needs to at least replace each unit of gas it produces with a like unit, otherwise it is just depleting away it's existing asset base. Therefore, the sale of each unit must generate enough excess cash flow to go replace that unit at a cost equal or below that excess cash flow. In the "old days" example this works out like this:

1) Drilling and completion cost of your latest well: $1,000,000
2) Size of new reserve from this well: 1,000,000 MCF (a.k.a. 1 billion cubic feet)
3) Fiding cost per MCF: $1,000,000 / 1,000,000 = $1.00 per MCF
4) Producing life (reserve life) of well: 10 years (note that production is not linear, that it comes on at the highest rate it will acheive and will decline over time due to reservoir and pressure depletion)
5) Lease Operating Cost per unit (to flow it from well, maintain well ops, etc): $1.00 per MCF
6) Sale price per MCF: $3.00

Therefore, each unit produced will generate cash flow of $3.00 minus $1.00 in lease operating costs, or $2.00 per unit. But now you have depleted your asset base by 1 unit, so what do you do? You take your $2.00 in cash flow and go invest it into a new drilling program. Since your finding costs are $1.00 per MCF for a 1 BCF well, you have the ability to replace your one unit produced with two more. This is essentially how you grow the company. In this case, your company would have the ability to replace reserves on a 2-to-1 basis. But note that producing one actual MCF unit doesn't actually get you two because you don't drill wells that are just two MCF in size. In the absence of borrowing money to drill, you actually need to produce enough of your existing reserve to get the money to drill the next well. In this case, you'd have to produce 500,000 mcf before you had enough money to drill your next $1MM well...this would take a few years.

So let's assume you have 10 BCF of total reserves at the begining of the example. You spent $10MM to develop those reserves and have total finding costs of $1.00 per MCF. Your average reserve life is about 10 years, so you are producing 1 BCf each year. You are therefore generating $2 in cash flow per MCF times 1 BCF for $2,000,000 per year. You can use that to drill 2 new wells at $1MM each and come up with another 2 BCF of new reserves. This would be considered a 200% reserve replacement ratio (2BCF new / 1 BCF produced). But although you replaced 200% of what you produced, your underlying reserve base grew by just 10%:

10 BCF - 1 BCF produced + 2 BCF found = 11 BCF.

In this case, you can grow your company's reserve base by 10% annually if you can acheive a 200% replacement ratio on production. Of course, if you have a bad year and you spend $2MM in drilling costs and only find 1 BCF of gas, you find that your reserves did not grow at all. This is essentially the position many of the larger integrated companies find themselves in: it is very hard to grow reserves once you get to a certain size.

So, how does all this relate to $7.00 gas? The fact is that finding costs on average have been climbing precipitously the last few years. We analyze operating data on over 75 publicly-traded exploration and production companies (micro-to-large cap, exlcuding the majors) and note that the average for 2005 was $2.77 per MCFe (the "e" stands for equivalent, meaning that oil volumes are included and converted to gas on a 6-to-1 basis). One year isn't all that meaningful, but we also look over 3 and 5 year drilling cycles to see how costs fare. We find that the 3-year average for our group is $2.50 per MCFe. We also note that the average per MCF operating costs are $1.60 for the group in 2005.

Therefore, in order to replicate the same economics as the "old days" example ($1-$1-$3), we need to generate a cash flow per MCF of double our finding costs, or $2.75 X 2 = $5.50. Given the $1.60 operating costs, that means that gas needs to sell for $7.10. So that is the short answer as to why I believe in $7.00 gas prices. While it is true that companies can replace reserves over 100% at levels below that, it is also true that they would not be able to generate any meaningful growth in reserves. Standing still at the same reserve level and merely replacing each unit you produce is not a way to create value.

All that said, there will be seasonal swings in prices. We will see prices well above $7 and well below $7. But the long-term average has to be $7 or so or "average" companies simply won't drill (that said, there are vast differences amongst companies' finding costs and operating costs - some will grow reserves at $4 gas and some can't do it even at $8 gas).

Also, I do not see any chance for average finding costs to come down significantly , but that is a topic for another day, when we can discuss why rig costs are not as important to overall finding costs as they once were (hint, it has to do with the type of reservoirs we are targeting and the nature of completions costs). And another day, we'll talk about why natural gas has become a more weather dependent commodity as prices have risen. Stay tuned...

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