Aftermath Of A Bubble And What Rises From The Ashes

Wolf Richter's picture

Wolf Richter

Bubbles are a funny thing. Participants don’t see them. Outsiders shake their heads – until they themselves get sucked in. Central banks support or create them, but deny their existence. Money piles in on top of money. Risks no longer exist. A technological innovation can serve as the logical foundation for unlimited gains. Yet invariably, it leads to mayhem, capital destruction, and devastating consequences for the industry. And a new beginning for the lucky ones. Take natural gas.

Thanks to the Fed’s zero-interest-rate policy and the trillions it has handed to its cronies since late 2008, boundless sums of money went searching for a place to go, and they were chasing yield where there was none, and so they took risks, any kind of risks, in their vain battle to come out ahead, and some of this money found its way to natural gas drilling. It coincided with innovation – the combination of horizontal drilling and hydraulic fracturing that unlocked vast reserves of natural gas in shale formations across much of the US. Result: a debt-fueled drilling bubble.

It ended in a glut that knocked the price of gas from its peak of $13 per million Btu to a 10-year low of $1.92 last April. Short sellers were out in force, predicting with intelligent-looking charts that over-production would fill storage facilities to capacity by early fall. Beyond that, any gas would have to be flared – that is, burned off to light up the night sky. And the price would drop to zero.

In other parts of the world, natural gas was six, seven, and in Japan over eight times more expensive than in the US. One of the most stunning discrepancies in a globalized economy. But the US, the largest producer in the world, has no facilities to export large quantities in form of liquefied natural gas (LNG), though there are pipelines to Mexico (export) and between the US and Canada (import and export). US gas production is essentially landlocked.

It was the darkest hour for natural gas. The industry was ravaged by a price that was far below production costs. Producers wrote off tens of billions of dollars – formalizing the misallocation and destruction of capital that Fed binges entail. They dumped assets to keep their heads above water. They shifted from drilling for “dry” gas to wells whose mix contained larger portions of oil and natural-gas liquids, which sold for higher prices and made wells profitable.

Production leveled off. Power companies switched from coal to gas. The San Onofre nuclear power plant in Southern California was shut down in January 2012 due to a radioactive steam leak and remains off line. Gas-fired power generators had to fill the hole. Other nuclear power plants were taken off line as well. And then there was a winter that turned out to be average, rather than warm. The Gods were starting to smile on natural gas.

But the bloodletting continued this year. Aubrey McClendon, CEO of Chesapeake Energy, the number two producer behind Exxon, was axed. On April 1, GMX, an Oklahoma City oil and gas producer, filed for Chapter 11 bankruptcy protection. It cited the low price of natural gas – which, by that time, had already more than doubled to about $4/mmBtu but was still not high enough for the company to survive intact.

The low price put pressure on drillers to innovate to bring down the cost of production. And they did; now there is pad drilling, for example. Environmental issues will be dealt with: the other option being mountaintop mining and burning more coal! As drilling has become more efficient, they’re drilling less: rig count plunged from 936 in October 2011 to 379 this week. Companies around the world have invested in US oil and gas fields to gain fracking expertise – which they’ll use around the world.

On Thursday, the Energy Information Agency reported that natural gas in underground storage, the primary indicator of over- or underproduction – a horror chart in late 2011 and early 2012 – had dropped 4.2% below the 5-year average and 31.8% below the level of the same week last year. Another step in a year-long trend of demand exceeding supply. Natural gas jumped 4.4% and closed at $4.40/mmBtu. Up 129% from its low a year ago.

Where to, from here? The price of natural gas is as volatile as the gas itself. It can crash because the weather isn’t right. It can spike because of shortages, real or imagined. Spikes occur regularly in regional markets where supply constraints during cold waves can multiply prices at local trading hubs by a factor 5 or even 10 in no time. As the price has risen to where coal is competitive again, natural-gas use for power generation has declined from last year’s phenomenal record, but is still significantly above the 2007-2011 range (EIA graph). Industrial demand is up. And everyone is still waiting for production to actually drop – the new version of the play, Waiting for Godot, who never arrives!

The big question: what is the cost of production of dry natural gas over the life of the well? Only estimates exist, every well is different, and all producers have their own calculus. But Christophe de Margerie, CEO of French mega-oil company Total, which is involved in shale gas projects in Texas and Ohio, let it slip that his company would not restart production of dry gas until the price reached the breakeven point. And then he disclosed what that point was – a crucial marker of where the price of gas might be headed. Read.... Natural Gas “Glut” Is Officially VERY Over.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
new game's picture

son works at baken on a "walking" rigs and it is amazing how many 1-2 mile holes they can do now compared to the old throwing tongs rigs. they all are going to these rigs or stacking out...

ps; run off is when the majority of the crew say get your pussy ass out of here (pink sliptime) and you best be heading out and back to the warehouse chance - make or break.  common experience for roughneck wannabees...

this happens due to saftey reasons as these people are dangereous and usually lazy dumb fucks thinking they are something they aren't.


Dry gas will be gold when LNG export opens in 2015, leases are being held by production until then. New pipes are creating accessibility, pretty soon Texas (and lower 48) will look like a pin cushion. As soon as the bombs drop on Iran/Syria, we will fly by the $6.00 breakeven and then it's open season. Obama may have a lot of sway on many sectors, but TPTB own the energy markets and will move however they see fit. I also see liquid money needing a new place to play and NG has been asleep for sometime.     

new game's picture

it is boom bust shit in you face econ 469 er

new normal > unintended consequences, everywhere.

market signals are fades, like stone wash denium.

rides the waves or sell that board...

long: farms for survival

disabledvet's picture

Not rocket science to say if your going to use natural gas to (wastefully) produce electricity you're setting yourself up for yet another massive price spike. (15 bucks was the peak the last time I recall.) so "back to coal it is" as this Administration and Government's complete lack of an energy policy is seen yet again. Obviously "buy energy companies as well." there will be no prosecutions it would seem...and this from a POTUS who's city of Chicago runs on natural gas. "new normal" dead ahead...

ebworthen's picture

Just imagine the hit, the surprise cost, to millions of households that rely on natural gas to heat their homes in the Winter.

From $1.92 back to $13 per million Btu?  Just imagine the hit to monthly utility bills, and thus consumer spending.

Roandavid's picture

Wolf does a good job, day after day after day.

adr's picture

Did Chesapeake go under because of the price of gas, or because of excessive debt and other bets gone bad?

Is natural gas above $4.00 because of demand, or because of the need for that price to cover speculative bets in other sectors?

I have a hard time believing that the incredible level of speculation and the 10k X increase in contract volume is demand based.

Demand is still far below available supply, yet the price is at the high end of the decade average. Supplies may be way below last year, but the five year average is one of the most distrted figures in the futures market.

How was it that Dominion could sell me gas with delivery charges profitably in 2004 for $2.15 per MCF, but now they claim break even is $4.00, with a $25 monthly base charge. Did demand really increase that much to coer the massive increase in supply over the last decade?

We were sold on "Energy Choice" and all we got was gas stored and supplied by Dominion, but sold by 100 different speculator held distributors. Two guys holding futures contracts could sell you gas, and never have to take delivery of a single tank. Most of these energy corporations are nothing more than a PO Box for receiving bills. The increased competition was supposed to lower prices, if the suppliers actually drilled, perhaps it would have. Instead all that happened was increased demand for futures contracts, which increased the price of the contracts. A complete Wall Street scam.

I say all published break even numbers are complete bullshit. The number contains the cost of operations that have nothing to do with drilling. Pensions, health benefits, lawsuits, market speculation. One of my colleagues left in 2007 to drill for gas with his cousin. He still says it costs less than $2 to get gas out of the ground. The rest is the corporate premium.

Exxon made billions of dollars when oil was $25 a barrel, yet two years later they were screaming they couldn't make a profit under $50 a barrel. Really?

How about we forget about publicly traded utilities and energy companies. We break up the giant monopolies and ban Energy companies from using funds to speculate in real esate, the stock market, and 100 other things that have nothing to do with producing energy.

We know from history that the larger a corporation becomes, the moe corrupt it is. The hands go in every cookie jar. How many independent drillers are left? How many independent refiners? Standard Oil didn't have the monopoly of the giants of today.

A small energy company might be able to drill and produce gas profitably at $2.50 per mcf. That company won't last long if the big boys make the claim that $4.00 is break even.

willwork4food's picture

Chesapeake Energy didn't go under-they just fired their CEO. Their stock is @ $18+ and they are paying a common stock dividend again. Fuck, I could have had this baby ten years ago for under 5.

Trampy's picture

If it happens before summer cooling season, NG should have tremendous resistance at the $5.00 level.  Best way to play that level bearish would be to write $5.50 calls.

otto skorzeny's picture

i like how NG has been climbing coming out of cold weather-what a joke. I sense the hidden hand of govt keeping NG up in price to prevent massive job losses and bankruptcies if NG would have kept falling

Pharming's picture

Hidden hand?  It doesn't seem too hidden to me with this administration.  There seems to be an abundance of horrible investments into wind, solar, etc... by our government and manipulation of pricing across the board.  The lack of faith and trust in deals is staggering to me.  I don't see how any credible business can function in this market unless you turn to the dark side.  When will it end.  When will we be able to invest in companies that are doing the right thing, are transparent, market a good product that isn't squashed by a regulation...


sosoome's picture

If the business model for natural gas worked, regardless of Fed policy, the industry would find financing, so I don't get how NG is an example of your premise. I can see how the Fed may have caused more sloshing around in the boat, but where's the bubble? Markets always go past the mean then revert.