The demise and resurrection of the natural gas industry

Borrowing from Mark Twain, the reports of the natural gas industry’s death have been greatly exaggerated. Words and phrases — like epic decline, demise, abandonment, crushed, confused, over-leveraged, bankrupt ideas and financially ill — have been used by many in the media and some analysts to define the state of the sector. Why? According to a recent article from USA Today, “the U.S. is producing more natural gas than ever in 2015, despite low prices that make it increasingly difficult for companies to spend money on drilling.”

Henry Hub-2015While the negative evaluation of the industry’s health sounds a bit premature, and perhaps hyped up a bit to sell papers as well as economic and market news on cable, there are real problems facing producers, refineries and distributors:

1. Gas inventories are higher than they’ve been in a long time. This fact, combined with decreased demand, has and will continue to put downward pressure on prices. While a hot summer kept the natural-gas market relatively stable (e.g., high demand for air conditioner use), the mild weather that’s projected for late fall and winter will exacerbate the gap between supply and demand as gas-powered utilities face lower consumer need for heat.

2. Natural gas prices have dropped by more than 30 percent since a year ago. Understandably, falling prices have aborted investment in new rigs and drilling. The recent decline in the development of new rigs and the abandonment or capping of older rigs dropped the number of natural gas rigs from near 1,600 in 2009 to just over 200 presently. But the totals are blurred because many rigs produced both oil and natural gas and were reclassified as oil rigs for investment purposes. The diminished production of legacy wells, even if demand increases, are unlikely to result in significant and immediate pressures on gas prices, given the extent of inventories and a recent history of annual surpluses. Assuming visible growth in demand, it will probably take 1-3 years for the equilibrium to return to the natural gas markets and for prices to move significantly higher. Instead, what we are likely to see is relatively short-term, modest up-and-down movements.

3. Bankruptcies, particularly among small and medium-size participants (e.g., drillers, suppliers, operators, etc.) in the gas industry, have and will continue to increase, leading to increased market share for larger firms.

More than a handful of lender/investors/bankers seemed to have benefited from the recent rise and fall of natural gas prices. Indeed, some skeptics, even more cynical than I am, have suggested that in the relatively recent past, Wall Street investors “orchestrated” gas gluts by investing in shale exploration knowing that prices, because of overproduction, would decline and transactional costs would be worth millions. In essence, bankers lent, production increased and prices declined. Subsequently, lenders sold – many on the upside of the down curve and many at bottom prices. Some generated mergers and acquisitions and, in the process, secured large fees. It’s a tough dog-eat-dog world out there.

I suggest the cynics are overplaying the ability of bankers to make what they believe are rational decisions and, contrary to law, work together to achieve nefarious ends. Right now, the financial industry, despite the rewards flowing to some for guessing right on recent short-term price movements as well as the values embedded in some firms, has tightened up on investment, whether equity or debt, for the capital costs associated with natural gas production and distribution.

Sorting out whether the current changes in the natural gas industry are likely to lead to permanent structural changes is difficult. We know there will be fewer firms, at the least at the outset of any long-term recovery. Clearly, starting new capital-intensive natural gas companies is more difficult, for example, than starting new housing firms after a down or unstable economic period.

It is surprising that an industry with an uncertain present and future seems wedded to playing only a minor role concerning the development and use of natural gas as a transportation fuel. Because of variables, related mostly to costs and access to infrastructure, only approximately 150,000 vehicles in the U.S. out of nearly 300,000,000 are powered by natural gas – either CNG or LNG. The industry, paraphrasing Israel’s former Ambassador Abba Eban’s comments on the Middle East, has and appears willing to continue to miss opportunities and therefore misses opportunities to commit, in a meaningful way, to use of natural gas as a transportation fuel.

In light of available technology, natural gas and/or its possible derivative, ethanol, would be cheaper for consumers and emit fewer pollutants and GHG emissions. Because of its abundance in the U.S., if used more extensively, natural gas and/or ethanol could reduce dependency on oil imports from currently unfriendly or potentially unfriendly nations. Neither natural gas nor ethanol are perfect fuels. But in terms of the environment, global warming, the price at the pump and national security, natural gas and ethanol are both better than gasoline. Both are welcome transitional fuels until electric cars, hydro fuels and other renewable fuels are ready for prime time.

Existing and proposed federal and state regulations already have and, in the future, will reduce methane leakage problems (e.g., methane traps significantly more heat than carbon dioxide and therefore is a potent global warming contributor) and hopefully respond to fracking problems.

Natural gas-fueled vehicles are generally more costly than gasoline-fueled vehicles. However, lessons learned from the multi-state demonstrations led by Gov. John Hickenlooper of Colorado (Democrat) and Gov. Mary Fallin of Oklahoma (Republican) show promise in reducing vehicle costs. Twenty-two states are participating in the demonstration. Collectively, they have agreed to purchase natural gas vehicles to replace older, internal combustion cars from state fleets. The “market scale” of the demonstration will facilitate an effort by manufacturers to develop cheaper cars. Finally, the growing number of Detroit-produced flex-fuel vehicles and the development of simple ways to convert older vehicles to flex-fuel status suggest an increased market for natural gas-based ethanol. Happily, technology is emerging that will be able to convert natural gas to ethanol efficiently and at a scale and cost necessary to respond, hopefully, to increased demand and compete with gasoline.

Socrates, the legendary natural gas philosopher, once said, “the unexamined [future business plan] is not worth [having]” (I only added a couple of words)., Paraphrasing the “The Elephant’s Child” from Rudyard Kipling’s “The Just So Stories,” the natural gas industry needs “six honest serving men” or women (my addition. Kipling was a sexist.) to develop a doable plan and strategy to expand the use of natural gas as a fuel. “Their names are What and Why and When and How and Where and Who.” The old way of doing business may be changing but a new, better way can be resurrected with expanding natural gas markets to develop a decent, competitive transitional transportation fuel.