Is a Natural Gas Supply Bubble Forming?

Natural gas prices have fallen sharply from where they stood earlier this year, and so have gas producers' stocks. During the swift market action, many of the Morningstar Ratings went to 5 stars for exploration and production (E&P) company stocks we cover. We've kept our attention focused on the ever-dynamic fundamentals underpinning our valuations for the E&P companies during this turbulent two-month period, updating our forecasts for lower near-term oil and gas prices.

Short-Term Fundamentals
Although we speculate that much of the magnitude of the recent drop in E&P stock prices can be attributed more to the financial health of large hedge fund players in the space (or lack of financial health), we have seen the short-term fundamental picture for natural gas producers erode in recent months. When we kicked off 2008, a relatively cold winter helped push natural gas prices much higher (above $12 per mcf) and plentiful drilling rig and services capacity--combined with more efficient development programs--kept well drilling and completion costs low. These factors contributed to margin expansion and lower reinvestment risk for the E&Ps (and higher stock prices). But these factors have changed over the summer. The rig market has recently tightened, especially in regions with particularly active drilling (like the midcontinent and North Texas). More visible to everyone, natural gas prices have come way down in recent months. So margins and incremental returns on new investment look set to contract for the near term.

Thoughts of a Supply Bubble Forming
A more ominous theory has been gaining steam across the industry, one that could potentially tip the scales of the longer-term supply and demand fundamentals some suggest. This thinking proposes that a natural gas supply bubble is building in the United States (one such discussion can be found at The Oil Drum here). Fingers point to the big natural gas shale plays and suggest the companies developing them could become victims of their own exploration success by creating a glut of new natural gas supply. They further point to the unusually large increase in U.S. natural gas production this year, which is likely to come in at 5% to 10%. While the rise of new production emerging from the new shale producing regions isn't a new concept--it has been a critical offset to falling conventional gas production in recent years--one shale play has captured the industry's imagination this summer and breathed additional life into the supply bubble argument: the Haynesville Shale in Northwest Louisiana.

All Things Haynesville
The Haynesville took center stage when  Chesapeake's  CEO Aubrey McClendon reiterated an estimated 245 trillion cubic feet in recoverable gas resided on a 3 million acre position there. For some context, the U.S. consumed about 23 trillion cubic feet of natural gas in 2007. So the estimated Haynesville resource would represent more than 10 years of current U.S. consumption. The Barnett Shale, which drew considerable initial interest in 2004, should produce more than 5 billion cubic feet per day in 2008 (or nearly 2 trillion cubic feet annually) and is estimated to hold up to 60 trillion cubic feet in recoverable gas.

We've spoken with numerous management teams (those both in and out of the Haynesville) to gauge the development and production potential for the Haynesville over the next few years. Building on these conversations and well results announced this year, we've tried to estimate potential production trajectories for the Haynesville. It's clear that industry has aggressive drilling plans for the region in 2009 (partially because many players are compelled to drill due to short-dated leases, in an effort to hold leases through production), and 100 rigs could be running toward the end of 2009. Further acceleration is likely in 2010 (with rig counts potentially topping 200 by the end of that year). Given these wells presently take about 60 days to drill and operators are likely to get more efficient as time progresses, daily production forecasts can easily range from 3 billion to 5 billion cubic feet in 18-24 months' time (or about 1 trillion to 2 trillion cubic feet annually). All of the Haynesville figures are a bit staggering, and its potential to single-handedly add 5% to 10% to total U.S. production over the next couple years would seem to support gas glut fears.

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