In his recent article, It’s a Gas, Gas, Gas, Robert Bryce correctly notes that the current price collapse and flat -- maybe even declining -- demand for natural gas has caused economic and financial turmoil for gas producers.

Gas prices are now about 47 percent below their July peak, drilling has slowed and the financial outlook for many producers is complicated by tight corporate credit markets and plunging stock values.

While there is no doubt that the US now has huge quantities of unconventional gas, the key question for the future is obvious: where are prices going? The technology breakthroughs in shale gas production are allowing producers to tap huge resources that were previously uneconomic. But these new shale resources are coming onstream at a time of weakening energy demand both in the US and the world. And there’s another wildcard: liquefied natural gas. Two recent reports are predicting near-record US LNG imports as new liquefaction capacity comes onstream at the same time that world gas demand is stagnating. All of these factors are combining to make for a complicated outlook for the US gas business.

Demand Growth and Pricing

The slide in prices started last summer. Natural gas prices fell in late summer as is typical with seasonal supply/demand flows. But instead of strengthening in early fall, prices just kept on falling. US natural gas in storage remains well above the five-year average of about 3.12 trillion cubic feet.

Demand for electric generation has not materialized even though coal plants appear to be at virtual pricing parity with gas combined-cycle plants. Very little coal-to-gas switching appears to be happening in the market, in part because the region with the largest amount of underutilized gas capacity (the Southeast) is dominated by regulated utilities with very competitive coal costs under contract and limited incentives to facilitate any fuel switching.

Despite the coldest temperatures of the season to date over much of the northern half of the country, natural gas prices remain under $6.Weather aside, natural gas for February delivery on the New York Mercantile Exchange was recently trading at $5.50, less than 40 percent of its record high price of $14.52 established just 5 months ago. The 12-month strip, which is the average for natural gas futures contracts over the next year, was priced at $6.13, a decrease of about $0.08, or 1.3 percent, from a week ago. On December 9, the Short-Term Energy Outlook from the Energy Information Administration said it expected Henry Hub natural gas prices to average $6.25 per thousand cubic feet in 2009, well below 2008's $9.17 average. And these numbers may be optimistic.

In October, the Natural Gas Supply Association said in its annual forecast that all the combined market forces (slightly warmer than normal weather, stagnant economic growth, moderate growth in overall demand, near record storage levels and a healthy supply) will cause flat price pressure on the gas market compared to last winter. The EIA expects demand next year to remain flat or drop from 2008 levels, as modest growth in residential, commercial and electric power consumption will offset by declining industrial demand. The industrial sector is now expected to decline by 2.5 percent. That contrasts with a 0.2 percent decline projected in the agency’s November report.

Then, on December 5, Dow Chemical announced that it would cut 5,000 jobs, about 11 percent of its workforce and close 20 plants. Natural gas futures in New York fell to a 15-month low after the announcement. The chemical industry, a keystone of the US economy, is the country's largest single gas consumer, accounting for more than 26 percent of demand. The prospect of losing demand at a time when production is growing could spell more downward pricing pressure.

A huge question now is: at what point will gas prices no longer support drilling and continued development? During the gas run-up that took prices from less than $3 to more than $9 in 1999 and 2000, the industry placed more than 600 drilling rigs into service. The sudden oversupply reversed prices. And by the end of 2001, prices were back below $2. Within six months 400 drilling rigs were laid down.

Today, the industry is experiencing another such pullback. With the marginal cost of production estimated to be $6.50 to $7.00 and higher in the eastern US, many existing projects may be economic at current prices but many of the newer may not be. With the futures curve below $7, it is difficult to imagine E&P companies drilling as aggressively as before and it will be interesting to see how much drilling activity tapers off over the next few months.

An October 12 report from Goldman Sachs predicted that 350 drilling rigs would be idled in 2009, and it cut expected earnings per share targets for drillers by 28 percent and by an additional 40 percent for 2010. By the end of November, the number of drilling rigs working in the Barnett Shale had fallen to its lowest level in about two years. And Tulsa-based driller Helmerich & Payne, one of the nation’s largest drilling contractors, told investors 400 rigs could be idled. And hopes that the reduced drilling will bring supply and demand back into balance by the second half of next year are being threatened by the possibility of LNG imports.

On December 17, Waterborne Energy released a report which predicted a 30 percent rise in global LNG production in 2009 and suggested that the U.S. import volumes could surpass the record set in 2007 of 2.1 bcf/d. That prediction is similar to one made by Jen Snyder, head of Wood Mackenzie’s North America gas research unit, during the Houston Energy Forum in November. Snyder predicted that LNG imports into the US will rise over the next few years, a factor that led Snyder to predict that US gas prices will trade in the $5 to $6 range for the next five years.

Formation, formation, formation

A highly publicized Navigant Consulting report promises that the U.S has 100 years worth of natural gas supplies and Boone Pickens’ TV ads promote the increased use of wind and natural gas use as the way to energy independence. This heady optimism about gas supplies is based on the production increases over the last two years when natural gas producers in 2007 pulled off the biggest annual jump in production since 1984 and repeated their performance in 2008.

US gas production is expected to be nearly 8 percent higher this winter than a year earlier, based on an analysis by Virginia-based ICF International . The Barnett shale has been the single biggest driver in US gas production growth. Barnett shale production is now about 4.4 bcf/d cubic feet per day compared with 1 bcf/d just four years ago.

With the Barnett behind them and the Haynesville Shale play ramping up, Oklahoma City-based Chesapeake Energy has said it will move 10 of its 43 Barnett Shale rigs to the Haynesville area, attention is turning to the highly publicized Marcellus Shale in New York and Pennsylvania. At first, it was thought that roughly 10 percent, or about 50 trillion cubic feet of natural gas was recoverable. Now, newly revised estimates from Penn State geoscientist Terry Engelder and State University of New York at Fredonia geologist Gary Lash place the shale’s recoverable gas potential at around 363 trillion cubic feet.

However, headlines about the Barnett and Haynesville shale successes have overshadowed the fact that these shale formations vary in quality from one part of the country to another. Clearly we are starting with the most promising formations and shouldn’t automatically project similar success for other regions. Improvements in technology have made a big difference in the amount of production that can be recovered economically to date. But technology improvements are likely to be smaller in the future.

With much of the new production shifting to regions with little previous experience such as New York, there are questions about whether the infrastructure exists to get the production to market. Ownership and right-of-way issues may make it difficult to get permits and there will be certainly more environmental push back, especially those related to groundwater. All of these factors are likely to raise costs for producers.

Credit and drilling

In the United States, natural gas tends to be produced by smaller, highly leveraged companies that will be disproportionately affected by the credit crisis. Under today’s economic environment, their business models will be hard to sustain. Many banks are counterparties on these transactions and will not continue to lend as prices plunge or remain low. Without outside sources of credit, companies are under pressure to keep capital expenditures within the funds that are generated by cash flow.

A growing number of gas producers are not able to get the sources of capital that have made their business models tick. Chesapeake has cut $4.7 billion from its capital budget over the next two years. The company has decreased its drilling capital expenditure budget for 2009 and 2010 by a combined $2.9 billion, or 31 percent, and has also reduced its leasehold and producing property acquisition budget for 2009 and 2010 by a combined $2.2 billion, or 78 percent. In December, Chesapeake announced that it would try to raise $1.8 billion through common stock sales to fund drilling and exploration activities. (But after its stock price plunged, the company quickly changed its mind.) Dunbar Resources, Petrohawk Energy, Quicksilver, and Sandridge Energy have all announced similar cutbacks. All of these firms were highly leveraged, maximizing production by carrying heavy debt loads and now have to cut back spending which was exceeding cash flow.

Industry had aggressive drilling plans for the Haynesville region in 2009, which may continue driven by the need to hold leases through production. As many as 100 rigs could be running toward the end of 2009. Further acceleration is likely in 2010. 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 range from 3 billion to 5 billion cubic feet in 18 to 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 percent to 10 percent to total US production over the next couple years would seem to support fears of a gas glut and low prices.

Where to From Here?

There is really little comparison between conventional and unconventional production. With conventional one well might produce 30 to 40 billion cubic feet of gas over its useful life. But an unconventional well might only produce a fraction of that. While these wells have an initial high production rate, it will drop off dramatically in a few years.

EOG Resources has estimated that production from the Barnett Shale will peak in 2009 at 4.8 bcf/d and then hold at a plateau for 2 to 3 years before gradually winding down. CEO Mark Papa notes that estimates vary and that some within industry expect the Barnett to peak at 6 bcf/d. Described as a drilling treadmill, as wells start their steep declines, companies must drill more wells to replace them. Considering that it is the growth in reserve volumes that drives their stock prices, they must continue to drill even if they only recover capital costs. Drilling more wells creates the need to drill even more wells in the future to maintain the same production. Although wells have a rapid decline, production is expected to decline to a low rate that can be sustained for decades as old wells provide a solid base of production.

Others argue that it is a mistake to characterize all unconventional production the same and low but long-term sustainable production may be more characteristic of coal bed production. But unlike coal bed methane wells, shale wells diminish to almost nothing during a 2 to 5-year period leaving no real residual base of production. The Barnett Shale may be approaching its production peak, and if the latter school is correct, a sudden drop in drilling would cause a dramatic production drop off. James Williams, energy economist with WTRG Economics, has noted that almost a third of current gas production comes from wells completed in the preceding 12 months. And data from the Texas Railroad Commission show production has been declining nearly every month this year.

If the credit crisis and current low prices persist for another two or three years, leading to a large decline in the number of rigs working in the US, questions about the long-term production profile of gas shale will be answered. Everyone will also be watching closely the decline rates for the unconventional fields as drilling slows.

The recent success in shale production has led to certain euphoria about an enhanced role for natural gas in our energy mix. The predictions that unconventional production would quickly reach a peak and decline was temporarily put aside by the record production of the last two years. Excitement about shale production has led some to announce that we will soon be self sufficient in gas. Now, renewed uncertainty about the economics of these supplies has turned the debate on its head. Will shale production allow natural gas to replace coal under a vigorous climate program and avoid creating new dependencies on foreign sources of natural gas? Will the demand be there to cause prices to rise enough in the short-term to continue the development of unconventional supplies?

In recent presentations, analysts at Merrill Lynch have gotten more bearish on gas in the near-term and long-term. They noted that as recently as June, the mix of drivers appeared supportive for even higher prices with a year-on-year storage deficit and lagging LNG imports. Since late summer, however, negative factors appear to dominate the near-term and long-term outlooks, including significant US production increases from shale gas and other unconventional plays, a weaker economic outlook and possible recession, lower demand over the summer, and the increasing role of renewables.

Producers are hopeful that the supply glut that caused prices to tumble will start to turn around in late 2009 and early 2010 and prices start to rise. A wild card is whether or not the new global liquefaction capacity coming on line in 2009 and 2010 will be soaked up by existing customers or, as some have predicted, flood into the US. If analysts are correct about the resource potential, the great challenge for the Obama administration will be to find a bigger role for natural gas in America’s long-term energy strategy. That will mean creating policies that increase demand and therefore elevate prices to levels that can help finance the next generation of shale gas plays.

Terence Thorn is a Houston-based gas analyst.