Barclays Capital energy analysts write that the question they are asked most is: why are US gas producers continuing to drill so much? Prices are low (especially against crude oil), storage levels are high, and demand has of course taken a hit from a downturn in industrial activity.
It’s something that the shale gas producers themselves seem a bit unsure of, judging from some past comments.
As BarCap’s James Crandall points out, aggregate decline rates from existing gas wells are about 30 per cent, so a drop in drilling activity could indeed affect supply, and prices, fairly quickly.
So then, why keep at it?
First, the producers are companies with equity investors — so they are motivated to keep increasing production:
While one would certainly expect investors to root for soaring gas prices, we suspect that investors, at the same time, are rooting even harder for production growth from the companies in which they have an ownership interest.
This is partly, says Crandall, because equity investors have less faith in a gas producer’s ability to predict prices than in its ability to keep producing gas.
And then there is the “prisoners’ dilemma” of production; a company that did have the support to restrain its drilling activity would simply see its stock fall as its competitors picked up its market share.
So, what if all producers cut output?
If all producers cut drilling and prices rallied, producers would soon be expected to announce expanded drilling activity. Call it ruinous competition, or perhaps one of America’s best inflation fighters, but as long as the production growth business model remains, it is hard to see how producers would shift their actions.
[Remember Opec, despite all its cartel-conducive features (no problem with fickle investors, for one thing), has managed to effect some improvement in crude oil prices despite a notorious lack of quota adherance.]
Crandall also says gas prices themselves are not a simple factor; futures prices may be more important than spot pricesand the steep contango seen today can put upcoming drilling developments in a positive light for both producers and their investors. And drilling projects do not turn on a dime, so prices need to be assessed carefully.
And there’s more: meeting production guidance, keeping to lease terms (some of which expire if drilling does not continue) and take-or-pay contracts can also affect drilling decisions.
However, despite the litany of reasons explaining why producers don’t cut output, Crandall and colleagues believe that gas producers are becoming more responsive to price:
We expect producers to begin announcing capex spending cuts for H2 10, starting in early summer. But these may not be accompanied by revised production guidance. If producers make rig efficiency gains again this year, they may be able to meet/beat production guidance while trimming capex, as was done in 2009. In the meantime, we expect the rig count to inch higher.
If low prices persist for long enough, that could be sufficient to overcome various obstructions to cutting production.