Capital Destruction in Natural Gas

Wolf Richter's picture

Wolf Richter

Dirt cheap natural gas over the last few years has done wonders for America—and it’s not just cheap compared to oil and coal but cheap compared to history: the April 19 low of $1.90 per million Btu was a level natural gas hadn’t seen in a decade. Beneficiaries are scattered across the country: households with lower heating bills, industrial users, utilities, even companies dreaming of building Liquefied Natural Gas export terminals to benefit from prices that are several times as high in the international markets. Dirt cheap natural gas is spurring innovation and manufacturing and hopes for a brighter future. And yet, it’s tearing up the very industry that is producing it, and capital destruction—mostly borrowed money—has reached epic proportions.

The travails of Chesapeake Energy and other drillers have been well documented. Their problem: a debt-fueled binge in horizontal drilling and hydraulic fracturing (fracking) unlocked vast reserves—how vast is being disputed—of natural gas in shale formations across much of the US. And the very success of that binge ended in a supply glut that drove the price of natural gas from a peak of $13 per million Btu years ago into the historic basement.

The economics of fracking are horrid. All wells have decline rates where production drops over time. But instead of decades for traditional wells, decline rates in horizontal fracking are measured in weeks and months: production falls off a cliff from day one and continues for a year or so until it levels out at about 10% of initial production. To be in the black over its life under these circumstances, a well in the Barnett Shale would have to sell its production for about $8 per million Btu, pricing models have shown.

At today’s price of $2.43 per million Btu at the Henry Hub—though up 28% from the April low—drilling is destroying capital at an astonishing rate, and drillers are left with a mountain of debt just when decline rates are starting to wreak their havoc. To keep the decline rates from mucking up income statements, companies had to drill more and more, with new wells making up for the declining production of old wells. Alas, the scheme hit a wall, namely reality. For that whole fiasco, read.... The Natural Gas Massacre Gets Bloodier.

The beleaguered drillers finally reacted, cutting whenever feasible their operations in dry shales (fields that produce only methane) and concentrating on wet shales that produce oil—still a profitable activity—and gas liquids like propane, butane, and pentane that are priced more like oil. Result: a collapse in the number of rigs drilling for gas. From 936 on October 14 last year to 588 last week. A 37% nosedive in seven months. The lowest count since October 15, 1999. The rout appears to be far from over:



The natural gas business is brutal. The peak in drilling occurred in September 2008 with 1,606 rigs. Then the financial crisis threw it into a vertigo-inducing plunge. After last year’s mini-peak, the plunge continued. Meanwhile, drilling for oil has picked up the slack in the most spectacular manner. Drill baby drill.

Production lags behind rig count, and while rig count for gas wells has been setting new decade lows, production has been rising month after month to new record highs. But lagging doesn’t mean decoupled. And someday.... Oops, it already happened. It has started. Production has turned the corner, and not just in one field, but across the US:



It’s still just a little notch in the curve. But it’s a sign that the collapse in rig count is translating into lower production numbers. And when the steep decline rates are beginning to overlap the drop in rig count, production will head south in a dizzying trajectory.

While drillers are getting slaughtered, power generators are laughing all the way to the bank. They have switched massively from coal to natural gas. According to the EIA’s just released Electric Power Monthly May 2012, net generation of electricity from coal-fired power plants fell 21.3% in March and 21.4% in the first quarter; but from gas-fired power plants it skyrocketed 40.2% in March and 33.3% in the first quarter.

The confluence of sharply rising demand from power generators and declining production has started to burn through the gas in storage—though still at a record for this time of the year. Fears were being mongered earlier that storage would soon be at capacity and that gas would have to be flared, thus making it worthless and available for free, bringing its price effectively to zero. This scenario now appears silly.

But there will be turmoil. Drillers continue to bleed. A cool summer could prolong the pain. It may drag out long enough to where some highly leveraged drillers that haven’t sufficiently diversified away from dry gas won’t make it. Their pain will continue until the price of gas rises to a point where fracking is profitable. Maybe $8 per million Btu for certain fields. And drillers, the survivors, will jump back into the game. But production can’t be turned on overnight. It will take time. Coal will become an alternative again for generators. And imports of LNG can pick up some slack, but with Japan paying north of $15 per million Btu, it’s hard to imagine that the US could buy it for a fraction of that.

And oil? Has it established a floor that will stick? Or is it getting ready to crash, given that drillers use the same technologies that brought on the glut of natural gas. For an excellent discussion, read.... Drilling Down into Oil & Gas Prices.

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adr's picture

A normal middle class family can't afford to heat their home in winter with nat gas rates above $7. That is a fact. If speculators drive the price above that level again you will see absolute decimation in consumer spending.

tempo's picture

Just like the housing and social networking bubble, the NG story/bubble was pushed by many elite, wall street and industry interests who bought leases cheap and didn't care about the well economies. Their intent was to package leases into billion dollar entities and sell shares pushing low risk return and cashflow to pension funds and other passive wealth investors. The rich screw the rich. The boom towns where leases were sold won. Tight gas frac drilling has been known for 50 years but the "new technology" allowed the insiders to tell a very different story about the economies to sell drilling to investors. Now its over. How could massive NG drilling help the USA when its manufacturing base has been destoryed.

Downtoolong's picture

Good summary. There’s another story that played alongside this one which had as much influence, perhaps more, on the price dynamics of nat gas. That’s the paper trade in the OTC derivatives and futures markets. You can bet the energy trading desks at the big banks were watching things in the physical markets very closely and knew all  along just exactly where to squeeze. It’s so much easier to do when it’s not your capital at risk. Of course, some of the ones doing the squeezing were also doing the lending, so, they made money on both sides of the squeeze. What a way to treat your (um) clients.

Capital destruction is right, and inevitable when you start running your capital intensive business on marginal economics. That’s exactly where Wall Street pushes you, so that guys like Ichan and Buffet can eventually step in and buy the physical assets for pennies on the dollar with virtually zero downside risk. The banks will be happy to finance that deal too.

Jim B's picture

The EPA has forced many utilities from coal to gas with new regulations on coal fired plants.  Our local power company is closing 2 coal fired plants because the upgrade costs are too high.  They are building a gas fired plant as a replacement (gas is not as efficient for generating electricity) and our electric rates are up about 30% in the last 3 years.  THANK YOU Dumbama and the radical EPA! 

LFMayor's picture

the eco tard watermelons (green communists) junked you man.  Didn't you know coal is bad?  Butterflies weep every time a shovelful is tossed into a cart.

And then your blasphemed their Mocha Messiah and the stalwart crusaders of the EPA, champions of humankind.

Implicit simplicit's picture

It would be interesting to see just how much the drop in NG prices has translated to a drop in price for consumers. I dont think it has, as NG household user. If there has been a drop, it is not even close to being in direct proportion to the drop in NG in the markets.The middlemen and Electricity producers are scalping larger marginal profits.

falak pema's picture

Short term, clutch energy play in a country doped on hyperconsumption, based on quarterly report mantra of Reaganomics age, sign of short term thinking in knee-jerk asset stripping capitalism paradigm, comes back to bite the hands that concocted it. Irony of capitalism gone viral. Not only is fracking proving to be an ecological mess but also an economic mess with its "instant cawfee" payout and depletion rout down the road. When you tout an economic model that is based on instant economic orgasm and down the road extreme retractive pain and strain on your magical wand of gung-ho, shag-a-lag karma, you are on a merry-go-roundabout that is worthy of the scenario of "Strangers on a train". Totally Hitchcockian and heading for Psycho torn curtain country. 

Strangers on a Train (film) - Wikipedia, the free encyclopedia

Psycho (film) - Wikipedia, the free encyclopedia

Kayman's picture

"Not only is fracking proving to be an ecological mess but also an economic mess with its "instant cawfee" payout and depletion rout down the road."

Serpent Girl, you got to get out of your basement once in a while. Go look at a drilling operation and stop being so damned book learned.

There's those that make it happen, there's those that watch it happen, and there's those that wonder what happened.  You aren't one of the bookends. 


falak pema's picture

Hey he-man, come out of your Cayman cave and learn to add and subtract, then we'll talk. This ain't book stuff, this is the stuff that economies live and die for. Frackgas is a bridge too soon, and maybe too far, in the search for quick easy solutions. I'm not saying the gas phenomenum is not real, I'm saying its far from optimal and will cause much pain like Thatcher did with north sea oil. She said "let her rip"; and it lasted twenty years. Tuff shit that-- let her rip--

Maybe, the US industry is saying 'let her rip' once more, and it will trip once more...So Kayman don't light your cigarette when you're in those confines. Take it from somebody who knows the workings of the Oli/gas industry, from very close up. 

TacticalZen's picture

This is the typical irresistible force and immovable object.

In only five years we found an incremental supply of NG that under current use rates would last 100 years.  It's equal (in thermal equivalent) to the total quantity of Saudi Arabian oil - just under 300 BBOE.  And, the cheapest horizontal drillers supposedly produce at or near the $4.00 per MMBtu mark and make money.  Some said $3.00 or $2.00, but that appears to have been boasting not fact.

The bad news is that the Feds (EPA) have taken it upon themselves to oversee (police) environmental issues around fracking.  If they want they could shut this entire industry down.  Under an Obama administration, should he be re-elected, that appears likely.  On a different front, the aggregate NG demand is down about 30% from the peak in 2007 - in commercial, industrial and power generation, even with fuel switching from coal.  That amount of demand is not going to be made up easily or quickly.

But the real wild card in the equation is banking - or the lack thereof.  The energy business is and has always been capital intensive.  But nobody wants to lend in the current environment.  So, projects will go begging for funding, and only those with cash will move forward and only on the most economic projects.  This helps to guarantee that the highs and lows will be more pronounced.  It is distortion squared.

I used to work in the natural gas industry and had a successful career in the business.  But that's long gone and won't be back in my lifetime.  I worked in Natural Gas from the beginning of deregulation in 1990 to 2010.  The people and firms that remain are only hanging on until the next banking collapse, when we'll have another dip down.

So, because of the banking and currency issues that cloud everything, even great innovation like finding a 100 year supply of energy, I'm remaining contrarian and moving dollars to gold.  Our society is simply too corrupt and too indebted to drink the kool aid.  My economic model is this - the corrupt bankers, in concert with government and industry, poisoned the well from which we all drink, and on which we all depend.  All who continue to rely on that vital resource will perish.  We should use the time to prepare and move as much wealth as possible "away" - away from the USA, away from stocks and bonds, and away from dollar denomination.  My radical opinions have changed from outrageous in 2008 to almost mainstream by 2012.

American Sucker's picture

Obama isn't going to shut down franking. LOL

mayhem_korner's picture



Come Shale Away!

(it's weak, I know)

ozzzo's picture

2007 is to the right of 2008 in the graph. Did you mean October 2011?

Herkimer Jerkimer's picture



The NG door-to-door ran around Canada in 2001-4 yelling the sky was falling, and that everyone should lock in prices before they went higher.


They knew fracking would kill the prices in a few years and they screwed us.


Ha!-Ha! on them!


Bring on the cheap gas!




RoadKill's picture

Bad analysis is bad.

Shale wells are no where near as expensive as indicated. You need gas prices or around $4 to sustain growing production. We will cycle between $2 and $6 based on over/under drilling and weather.

We had the warmest winter on record. So prices are at the low end of the range. Less drilling and normal weather will have us back to $4 or $5 this winter assuming summer and winter weather are normalish.

AGuy's picture

Fracking insiders have stated in the past that the price of NatGas needs to be between $12 and $18 per mmbtu to make a profit. Price depends where the well is located as some areas are more expensive than others. NatGas Infrastructure is more expensive, because you need pipelines between the well and the consumer. You can't store it and transport it in tanker. This adds to the cost, especially if the typical Frack well is depleted in 18 months.

Fracking reminds me of  the past bubbles, Internet stock bubble and later the housing bubble. History shows that many of these fades are ripe with false information and fraud, that later collapse. The worry is that the hype with fracking is setting the stage for a major issue. Consider that conventional wells are beening drained at an alarming rate becuase of the false believe that NatGas from fracting is abundant and cheap. When reality hits the market we will have a serious problem because depletion of existing convential NatGas wells. Its also tragic that power companies are pouring billions into NatGas fired turbine plants on the believe that NatGas will remain cheap for decades. Power companies are not developing other sources of power which will bring about either very high electricity prices and/or rolling blackouts in the United States. Washington and the frackers have sold American's on another fraud.

2000: Dot Com Bust

2008: Real Estate Bust

2015?: Fracking Bust


Offthebeach's picture

Rockefeller made his fortune rartionlizing wild oil prices and market consumption. Nothing new in the NG story. Not a consumers problem. I wouldn't doubt Obama/EPA support by some producers to snuff out other producers. Just like Soviets paid German lefties to protest Nuclear. And Saudis and Venezuelans paying US lefties. Just call it " green " and wave a check and you can buy all the Obama lefties you want for less than the price of a junkyard used SAAB door.

sangell's picture

Using natural gas to generate kilowatts is about as dumb as using oil. The molecule is far too valuable to be used for that. I also just bet electric utilities are running peaking plants for base load ( as like Japan is having to do) and come July and August a lot of them won't be operative because natural gas is being consumed like booze at an all you can drink party.

otto skorzeny's picture

Can't figure out what is going on in NatGas- are they just batting it back-and forth from 2.30 to 2.60 or has it found a floor  at 2.50 to go higher(3.50-4.00) quickly? the weather in midwest seems to be returning to a typical summer after a warm start.

Catullus's picture

Get on those $8 calls, dudes.

Hahaha. Holy shit this is terrible analysis.

Rig count is down because gas production has become more efficient. And gas production deteriorates over years, not hours. And those modeled decline rates could be complete bullshit.

Power plant operates laughing all the way to the bank on the coal to gas switching?! Let's look at NRG. Nope. Calpine. Nah. Dynegy?! Not so much. Coal dropped with gas. Gas is barely below the coal floor across PJM. Exelon even said they're modeling $4gas as "rational" long term.

New_Meat's picture

TXU sacrificed several of their NG units ~2 years ago. - Ned

[then changed their name again ;-) ]

Catullus's picture


It's still the worst LBO in the history of leveraged finance.  The most amazing thing is that Goldman extended their debt I think last year.  CC-.   With the interest rate swaps, I think they've locked it in around 7.5%.

disabledvet's picture

i'm not sure i understand "flaring off" the gas. once you do that "it's worthless." you've already drilled the might as well get the buck per btu.

fnordfnordfnord's picture

What they meant by flaring off the gas is that they may have to waste it if the storage terminals are full (there is no place to put it).

Whatta's picture

Well, if there is no pipeline capacity to sell shut your wells in. I know of no one that flares gas other than during well completion.


fnordfnordfnord's picture

Maybe you should educate yourself about the downstream end of the business.

glassman's picture

The well is flared off after fracking to burn off the dangerous gases. Flaring usually last a few days.

Paul Bogdanich's picture

Depends.  Shallow gas production in Virginia, West Virginia and Alabama have decline rates of less than 2% a year.  But the Texas and Oklahoma shale plays decline real fast.  Also the surprising thing is how fast they managed to constrict suply.  Can't do that with oil unless you shut in the well.  For gas they just stop drilling the high decline fields and the supply starts to fall right off. 

AGuy's picture

"Shallow gas production in Virginia, West Virginia and Alabama have decline rates of less than 2% a year."

That's not fracking. I believe all of the shallow gas production in those states occurs from extracting methane from coal deposits, not shale.

eddiebe's picture

It's a gas! Buy the dips.

dododo's picture

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Bollixed's picture

That is the worst spun spam I've ever seen. Did you eat a lot of paint chips as a child?

lewy14's picture

It's a spam bot, and it's actually pretty good.

Its purpose is to evade the spam filters and post a link to its target site, in order to raise the target's page rank.

The page rank algorithm now uses some context around the link, so those words are important.

The rest of the gibberish looks like a simple n-gram generator seeded with some key terms and relatively infrequent words (which serve to throw off the spam filters).

In short, it was written by a computer, to fool other computers. It makes no sense to you because you're a human, and irrelevant in its world...

...kinda like the financial markets, and the trading therein. 

jeff montanye's picture

it's better than any of my (non existent) second languages, but i don't try.  what do you figure, online ? to english dictionaries?  original language very different in syntax (non indo european?).  intriguingly badly done.

Jim Billy Bob James IV's picture

I hold a lease in Johnson County, TX just south of Fort Worth.  Chesapeake drilled one well and produces as little as possible to hold the lease (until market conditions improve so I am told).  What is the saying about a bird in the hand...........

ebear's picture

>>I hold a lease in Johnson County, TX<<

I had a farm in Africa...

Herkimer Jerkimer's picture

"until market conditions improve"




That's called collusion. We'll just constrict the supply so the price goes up!



Jim Billy Bob James IV's picture

I hold a lease in Johnson County, TX just south of Fort Worth.  Chesapeake drilled one well and produces as little as possible to hold the lease (until market conditions improve so I am told).  What is the saying about a bird in the hand...........

Whatta's picture

The article sites $8 as the needed price for Barnett to be economic. That isn't the whole story. There are still wells being drilled in the play as some areas are more productive than others.

Johnson County has been, or is, one of those areas.