The capital markets versus the more adventurous drillers


When things are bad in the oil and gas business, the operators tell each other that “the cure for low prices is low prices”. Low prices for the product encourage more use, and discourage drilling and associated development, so supply falls and then prices come back.

That may not work so well this time for the US gas industry.

The gas-directed exploration and production people in the US industry were hit by price declines much earlier than the oil producers. The Henry Hub futures price strip only hit bottom in the spring of 2012, and has been fitfully recovering since then.

Still, even as the oil price drifted down over late summer, and then plunged from October on, the gas people thought they could see the end of their own tunnel. They had what looked like a solid international arbitrage working for them: with gas prices in Asia and continental Europe linked to oil, the US producers had enough of a cost advantage to justify the construction of liquefied natural gas export facilities, along with the associated pipelines and processing plants.

These LNG export terminals would start to buoy the US gas price by 2016, just in time to keep the exploration and production people a step ahead of the junk bondholders’ lawyers. The US would be an energy export superpower, and could continue to put off devising a coherent foreign policy.

Unfortunately for those depending on this vision, there appears to have been a capital markets supercycle within which the energy supercycle has been spinning. Over the past weeks, there is evidence that the low world oil prices could prolong the period of low US gas prices. Sometimes, it seems, low prices do not cure low prices; they make them lower.

Without the new markets that are set to be created by the US LNG export terminals, the gas industry could find its product stranded in an oversupplied domestic market that is insufficiently connected to the rest of the world to recover as quickly as it hoped.

The LNG export terminals are multibillion-dollar facilities with long lead times for permitting and construction. The gas people, particularly those in the low-cost but underconnected Marcellus plays in the northeast, had been counting on the capital markets’ willingness to finance the export facilities on faith. But faith is not as strong as it was long ago in late November and early December.

When I last counted, there were about two dozen US LNG export facilities that had been proposed. The four LNG export facilities that are already under construction, which have contracts to back up their financing, will almost certainly be finished. Then there are 10 facilities that have contracts, though not all of those necessarily have enough hard contracts to satisfy their lenders. The facilities that do not have sufficient contracts from customers, and have not already started construction, are at risk of being indefinitely postponed, if not cancelled.

By the end of this quarter’s earnings reporting season, we should have a better picture of how much export capacity will really be ready by 2017, or even 2018. Not a complete picture, though, as Enterprise Products Partners said in its call to analysts last week, that they “have no clue how low oil prices would go”. This is the sort of language, that, while refreshing, is not what you use with a banker to justify a highly leveraged project.

A further complication is that some of the customers who signed contracts for LNG terminals may now be willing to cancel them. Andy DeVries, senior analyst at CreditSights, the research provider, who, by the way, spotted the problems of the natural gas liquids markets early on, thinks that is the direction the Asian market is going.

“Think about it,” he says, “If you are an Asian buyer with a 20-year deal, you are guaranteeing hundreds of millions a year for a terminal when you could buy the gas for far less in the spot market. Maybe they will pay [a break-up fee of] a couple of hundred million and cancel the contract.”

So the future of the US gas industry is a race between the high decline rates for new unconventional gas wells, and the associated gas from oil wells, and the cancellation or deferral rate for new LNG export contracts.

Kendall Puig, an analyst at Bentek Energy, the Denver consultants, says: “We expect natgas prices to remain depressed for at least the next two years as supply continues to outpace demand. We don’t expect any significant demand response until the 2018-2019 timeframe, at which time prices could gain substantial support due to LNG exports.”

The unconventional exploration and production industry has done an impressive job since November in cutting costs and focusing development plans. Unfortunately, if the capital markets do not support the expansion of export capacity, their efforts may not be enough to save the more adventurous drillers.