LONDON: The recent rise in US natural gas prices, if sustained, will provide an opportunity to identify the threshold that drillers need to cover their marginal costs, the closest thing to conducting a controlled experiment possible in real-time markets.
Concerns about peaking oil and gas production are over, but the question about peak prices is still very much alive.
The shale revolution has ensured there will be sufficient oil and gas but left unanswered the more important question about what price will be needed to make sure they are available.
Relatively rapid decline rates on shale wells mean production companies have to keep up an intensive pace of drilling to replace declining output from existing wells, let alone produce net new supplies.
However, forecasters and producers are still struggling to identify the long-term marginal cost of shale oil and gas, which is likely to set the long-term floor for petroleum prices.
It is clear that US domestic gas prices have been below their sustainable level, while oil prices are above it, but the exact level of floor prices for gas and oil remains unclear.
The number of rigs drilling for gas has fallen more than three-quarters since August 2008 from around 1,600 to just 375, while the number drilling for oil has tripled to more than 1,350 from 400.
In 2008, four times as many rigs were being directed at gas-rich rock formations than at oil-bearing ones. By 2013 the situation had been reversed, and there were almost four times as many rigs drilling for crude.
The sharp slowdown in gas drilling appears to have halted the relentless rise in production, even allowing for a big jump in associated gas output from oil wells.
Dry gas production has shown smaller year-over-year gains since March last year, and in January 2013 it actually fell compared with the same period a year earlier.
It was the first year-on-year decline since March 2010.
Meanwhile, oil output jumped 815,000 barrels per day (bpd) last year, the biggest annual jump on record, and will rise another 830,000 bpd in 2013 and 570,000 bpd in 2014, according to the Energy Information Administration (EIA).
Rising oil output is far outstripping domestic demand growth. In fact, demand is currently falling because of ethanol blending and more stringent vehicle efficiency standards.
So from the supply side it is clear oil prices must fall and gas prices rise to give drillers an incentive to shift at least some rigs back from drilling oil and liquids-directed wells to dry gas plays.
From the demand side, too, there is pressure for a re-alignment to push prices closer to parity on an energy-equivalent basis. At present, oil is more than six times as expensive. Unless the gap shows signs of narrowing, oil will lose substantial market share to natural gas in sectors such as transportation and heating fuel.
The first part of this re-alignment may get underway later this year as gas prices rise to curb some of the rapid rise in gas-burning by power producers and incentivize exploration and production companies to turn their attention back to developing more gas supplies.
Spot gas prices have already doubled over the last 12 months from a low of under $ 2 per million British thermal units to more than $ 4.
Most analysts put the long-term sustainable price floor somewhere between $ 4 and $ 6 based on marginal costs.
As prices rise relative to oil, it should reveal more about the price that producers need to resume capital expenditure on gas drilling programs and help identify the lower threshold for sustainable prices in the long run.
In practice, identifying threshold prices will be complicated.
On the supply side, most wells produce a mix of crude, natural gas liquids and dry natural gas in varying proportions.
The large number of oil wells now being drilled are producing substantial volumes of associated gas as a byproduct.
Most gas wells produce some liquids, and drillers have recently been targeting the most liquids-rich gas formations to help offset low dry gas prices.
Drilling has also become much more efficient over the past three to four years, with rigs able to drill deeper wells with longer horizontal sections in less time.
The result is that the same number of rigs can now drill far more wells than before.
The reduction in gas-directed drilling rigs overstates the slowdown in new gas production.
Far fewer rigs are likely to be needed now to maintain and increase gas output than in 2008, so the market may need to shift only a few hundred rigs back to gas drilling.
Finally, on the demand side, record quantities of cheap gas have been burned by power producers in preference to coal.
As gas prices rise, the fuel is likely to give back some of its market share, which will help rebalance the market, even without an increase in drilling.
Drilling may not react immediately to price increases.
Many production companies are likely to wait and see whether higher prices are sustained before committing to more expensive drilling programs. Given the legacy of corporate debt carried over from the earlier drilling boom, many firms also may focus on using cash flow to reduce their leverage first.
Nonetheless, analysts and producers themselves will be keenly watching for signs of a resumption in gas drilling and what prices are needed to move the rigs back onto dry gas plays.
— John Kemp is a Reuters market analyst. The views expressed are his own.
Gas drilling: Production viability in spotlight
