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North America is undergoing a natural gas revolution. The first part of
the story is pretty well known: the advent of horizontal drilling and fracturing
technologies unlocked huge shale-gas reserves across the continent, and the
ensuing flood of production cut the commodity's price in half. In January
2011 the spot price of natural gas in the United States averaged $4.49 per
million British thermal units (MMBtu). Today, the
price is just $2.20 per MMBtu in the US, while in
certain areas in Canada production is selling around C$1.80 per MMBtu.
Most of America's gas producers simply cannot make money at that price.
Companies are cutting back on output levels, but it will take at least a year
before those cutbacks start to ease the country's supply glut. And the glut
is massive: there are currently 2.38 trillion cubic feet (TCF) of produced
natural gas sitting in US stockpiles. That is 47% above the level at this
time last year and 54% higher than the five-year average.
This part of the story has been covered at length in the mainstream
media. Much less discussed is the path forward for natural gas. Sure, there
are lots of general comments that the market will remain depressed for some
time, but what does that really mean? And more importantly, how can an
investor look to profit?
It's a complicated scenario, so today we will go through just one aspect
of America's natural gas conundrum: looming reserve downgrades. Reserves are
an estimate of the amount of gas in a reservoir that can be extracted
economically, which means that reserve volumes depend on the price of gas.
When the price falls by 50%, reserve volumes soon have to follow suit. These
major reserve downgrades will send damaging ripples across an already
delicate sector, creating both chaos and opportunity.
The ability to tap into shale-gas reservoirs created nothing less than a
paradigm shift in the natural gas sector: the rules of the game changed and
now all the players, consumers, and speculators are being forced to adjust.
Energy-market evolutions like this demand nuanced investment responses based
on multiple catalysts and forecasts, some of which receive endless attention,
while others – like the looming downgrades – take almost everyone
by surprise.
That "almost" does not include us. Natural gas is a complicated
game right now, but if you want to play, we've got your back. (I'll be
revealing a host of hidden energy-sector plays – including specific
companies that have outsized profit potential – at the upcoming Casey Research Recovery Reality Check Summit.)
Describing Size
Size matters, especially when it comes to resource deposits. Potential
partners, offtake customers, and investors always
want to know how many tons of coal, barrels of oil, ounces of gold, pounds of
copper, or cubic feet of natural gas a project contains. However, the size of
a resource alone is not enough.
The other key number is the reserve count – and not all resources
are reserves.
"Resources" describe the amount of a commodity contained in a
deposit. A geologist assesses the drilling results for an area and estimates
the total amount of oil, gas, or gold in the ground at that site.
Just because a resource exists does not mean that it is technically or
economically feasible to actually recover it. That's why reserves are a
subset of resources. First, geologic and technologic factors determine the
resource recovery rate, which reduces the resource to the parts that are
"technically recoverable." Then economic considerations kick in,
further reducing the resource to just the bits that are "economically
recoverable." The image below from the United States Geologic Survey
illustrates this whittling-down process.
Of course, the full breakdown is much more detailed than that. To
incorporate all of the factors that influence the economics of production,
total reserves get broken down into several subsets:
Proven reserves: those
reserves with a reasonable certainty (usually at least 90%) of being
recoverable under existing economic and political conditions, with existing
technology. These are also known as 1P Reserves.
·
Proven developed reserves can be produced from existing wells or from additional reservoirs with
minimal additional investment
·
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Proven undeveloped reserves require additional capital investment (i.e., new wells) to bring the oil
or gas to the surface
·
Unproven reserves: those
reserves with less certainty of being recoverable under current conditions
because of technical, contractual, or regulatory uncertainties
·
Unproven probable reserves carry a 50% confidence level of economic recovery. Adding these probable
reserves to a project's proven reserves gives the 2P Reserves
·
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Unproven possible reserves carry a 10% certainty of economic recovery. Adding these possible
reserves to a project's proven and probable reserves gives the 3P Reserves
·
The Economics of America's Natural Gas Reserves
In valuations, it is a company's 1P reserves that really matter. 2P
reserves are also interesting, but companies are always trying to upgrade
their 2P reserves to 1P status because investors, partners, and customers
only really care about the oil or gas that carries a 90% certainty of being
economically recoverable today.
The most important factor in calculating 1P reserves is commodity price.
The netback a company will earn on each barrel of oil or cubic foot of
natural gas starts with the realized sale price. If that price is too low,
all the costs associated with producing the commodity will pull that netback
into the red. Once that happens, the reserve is no longer a reserve because
it ain't economic.
Over the last decade, the price of natural gas averaged US$5.82 per MMBtu, which is three times its current level. A
decade of high natural gas prices did two things. First, it encouraged
massive exploration efforts, which were highly successful because of the
debut of horizontal drilling and fracturing. Second, it ensured that great
swaths of the resources delineated during that exploration mania were
economic. The combination pushed US natural gas reserves way up.
At this point our headline is probably starting to make sense: natural
gas reserve downgrades are coming. The price of natural gas has been cut in
half. The correlation is not so direct as to allow us to say that reserves will
now fall by half, but we have done calculations on many companies and have
determined many will have to downgrade their natural gas reserves by 40%.
Few companies have publicly re-assessed their gas reserves using
contemporary prices, so this concept has not yet hit the mainstream. A few
analysts have run numbers on the gas producers they follow; 40% losses are
standard. It only makes sense: far less natural gas is economic to produce at
US$2.20 per MMBtu than at $6.
With every downturn comes an opportunity. With natural gas, the
opportunity will be to pick up producers after these reserve downgrades
depress their share prices. As always, the hard part will be
knowing when they have hit bottom.
It's a challenge I have embraced. With my analysts, I have developed an
innovative computation that will let us see when a company reaches a
valuation consistent with its re-assessed 1P reserves. Our models will warn
us when one of the companies on our watch list (which includes companies that
already passed through our other analytical wringers) reaches its new real
valuation, priming us to watch for the moment to move.
Not every natural gas producer will survive the next 12 to 24 months.
These looming reserve downgrades will shock an already depressed market, and
companies without the financial stability to weather the storm will sink.
Making matter worse, lots of gas producers hedge their output – and the
juicy hedges that reflect out-of-date high prices will come undone later in
the year.
The smart investor will anticipate reserve write-downs. When the market
punishes the sector, buying opportunities for certain companies will arise.
Companies that survive the next few grueling quarters will be rewarded with a natural gas resurgence. Stockpiles will fall, demand will
rise, and prices will recover. It will not happen quickly, but it will
happen… and when it does, we will be ready.
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