A second historic example: the gas crash of 2008

A second example which may also be instructive to the current situation in the oil markets is the 2008 crash of NYMEX natural gas.  The gas price crash of 2008 pertains only to a local market (USA) since US gas is isolated from the international market.  But it may be instructive to look at because the production curves are similar to  unconventional oil wells, and the companies doing the producing are those same companies adding all the excess supply currently.

The US gas market is different than the world oil market in a number of key ways.  Besides being a much smaller than oil, there is also very limited storage availability and strong seasonal use in winter.  This can lead to price spikes during the “draw season” (when storage facilities are drawn down).  Both of these things increase price volatility.  There is also another factor which reduces price volatility.  Because much of the gas produced is used for electrical generation, it is substitutable, to some extent, with coal.  Natural gas turbines are relatively cheap to install, so utilities don’t mind leaving them idle if the price is high, as long as they have other options for generating power.

During the first half of the last decade gas production was in decline in the USA and there was a worry about a shortage.  This spurred investments in expensive LNG import terminals (terrible investments as it turned out).  Then came the shale gas boom.

A Brief history of the US Shale gas boom

(This is not researched and mostly from memory so let me know if there are any inaccuracies)

The Barnet Shale in the Fort Worth area was the first shale region that was actively produced.  It turned out that gas could economically be produced from a huge area if hydraulic fracturing and horizontal drilling were combined.  Companies like Devon Energy, EOG, Chesapeake Energy, and Encana were all early producers.  Shortly after, three other plays were discovered.  There was the Fayetteville Shale, in northern Arkansaws, The Haynesville in East Texas, and the Huge Marcellus Shale in West Virginia, Pennsylvania, and South-Central NY state.  Companies rushed to stake their claim to these huge geographic regions.  The rig count went sky high.  Production started to outpace demand, and the price crashed (after a speculative bubble in 2007 and 2008, but that’s a different story).

 Something interesting happened when the price crashed and the rig count along with it.  The production continued to increase!   How did this happen?  It is instructive to look at the individual regions.

First there is the Barnett, where the whole shale gas boom was kicked off.  Production stayed largely flat after the price drop, despite a huge drop in the rig count.

One reason that the regions tend to level out rather than declined is that in many cases there are firm take-away agreements between the gas producers and the pipeline companies, so they get penalized for producing below a certain level.  We are seeing this currently with Chesapeake in the Haynesville region.  Other reasons are that the pipelines were built, well pads and roads built, seismic studies conducted.  The land was leased and much of the land was also held by production.  All of this decreases the incremental cost of drilling additional wells.

The production increases since the crash have been driven almost totally by the Marcellus (South Texas Eagleford can take a bit of credit too).  Marcellus production was slow to take off because there was much less infrastructure in this region compared to Texas and Louisiana.  But the geology is much better than the other shale regions.  In fact, production now is mostly constrained by the ability to move the gas and NGLs to market, rather than by price even though pricing is terrible in the region, with realized prices far below the NYMEX price.

How does this relate to the current situation in oil?

The current world oil production growth is driven almost totally by unconventional oil production in the USA.  This production growth is exceeding world demand growth causing an oversupply situation.  We will not see prices stabilize until production and demand are matched.    Will the lower prices spur higher demand?  Will OPEC try to balance the market with cuts?  Will high priced production turn off to balance the market?  It is impossible to say for sure.

One thing is sure though.  We have not seen the cuts in investment so far that would indicate that the current price decline is adequate to balance the market.  It may be that it will just take more time at these prices for an effect to be seen, just as it took several years for the gas rig count to decline fully.  But the lack of a producer response does suggest that further price declines will be necessary.

If prices stabilize or go down another $10 or so from here, I wouldn't be surprised if we see a substantial decline in the US rig count and capex, but continued production growth from the most efficient producers in the most efficient regions.

There is an OPEC meeting on the 27th and I we may get a substantial price move in either direction on next Monday.  Buying either calls or puts on E&P companies this week might be a good idea.

(All charts are from Baker Hughs rig-count or EIA.gov for production)