||Tom Haywood and Mark Davidson
The economics of US shale oil production have improved dramatically in the last month or so even as crude oil benchmark prices have held at $45-$50 a barrel. The extra boost for shale oil is coming from US natural gas prices, which have rocketed up over 80% since their March low -- a 16-year nadir in nominal terms and probably some of the lowest US gas prices on record in real, inflation-adjusted terms. The July Henry Hub futures price hit $2.917 per million Btu at expiration, up over 50% from $1.90 in mid-May, with further signs of possible strength. With almost all shale oil production resulting in associated gas and most shale gas production generating some liquids, it is the combination of these commodity prices that determines the true economics of shale. Traditionally, it was high prices for liquids that "subsidized" economically marginal shale gas, but now gas is providing a big boost of its own. US independents that were on the ropes, even those in Chapter 11 bankruptcy, are getting a new lease on life. Not only has the decline in active drilling rigs for oil bottomed out and completions of already drilled wells jumped, but forward hedging in both oil and gas has surged as producers seek to protect future cash flow with their sights set firmly on returning to growth.
The US gas market has been taken by surprise -- surprise by the rather obvious facts that summer can be so hot and prices can rise so quickly from extreme lows. In June, bullish physical fundamentals set a fire under gas futures that pushed the July expiration to $2.917 per million Btu, up almost $1 from the June settlement in late May. In many ways, June trading was a scramble to price in some fairly normal summer conditions, but ones that many seemed to have lost sight of amid the spring price slump.
Henry Hub – Gas Futures Prices
Chief among them, storage has seen a 34% plunge in the surplus to the five-year average in roughly two months from about a trillion cubic feet in April to 599 billion cubic feet today. At this rate, you could surmise that the seasonal surplus will be close to 250 Bcf by winter, a view held by a number of analysts who expect inventories to top out between 3.8 Tcf and 3.9 Tcf. If this view pans out, then what's left of a huge price-dampening overhang could be eradicated by even normal winter demand. And as the El Nino pattern responsible for the warm North American winter gives way to a developing La Nina pattern, forecasters are anticipating a colder winter than last year.
However, this scenario also assumes that summer demand drivers stay the course. Record gas burns for power generation have cut the usual summer refill by 56% to date. Last week's data from the US Energy Information Administration (EIA) is typical of deliveries to storage. The EIA reported a net change of 39 Bcf, well under the 77 Bcf five-year average. And this week's delivery should be similarly shy of the seasonal norm because gas burns for power generation continue to run at record highs. Reuters reports burns have averaged 26.3 Bcf/d per day so far this year, up about 2 Bcf/d from last year's record. Meanwhile on the supply side, the damage of low prices and reduced drilling has depressed US gas production slightly from year-earlier levels and active gas rigs are still drifting lower.
But as bullish as this sounds, taming the surplus will require that gas burns continue at current levels, which is not assured even if it remains unusually hot. Gelber & Associates analyst Kent Bayazitoglu said last week that power generation from natural gas may have peaked in parts of the Midwest as gas-fired capacity is tapped out in some Midwestern states. But more bearishly, coal generation is coming back on line as natural gas prices rally.
Back From the Brink
In the weeks leading up to SandRidge Energy's bankruptcy filing in May, natural gas prices were flirting with the $1.90s per million cubic feet and crude oil was struggling to crawl back above $40/bbl -- all of which contributed to the company's $4 billion debt load. Today, thanks to sustained rallies in both commodities, SandRidge and other E&P companies mired in Chapter 11 have new leverage as they seek to exit the bankruptcy process later this year. That is particularly true of debt-for-equity arrangements, in which bondholders will end up owning most or all of the producer's stock post-bankruptcy.
"It changes the sentiment of the creditors," said Dallas Salazar, CEO of Austin-based Atlas Consulting, which often works with shareholders of E&Ps in or on the verge of bankruptcy. "If oil and natural gas prices are screaming higher and you are stuck in court and not able to take advantage of that, you have more incentive to work with the company to exit bankruptcy more quickly, even if the deal on the table isn't the greatest."
Debtor-in-possession financing -- in which creditors float the company enough money to continue operating through the court process -- typically allows a producer to maintain drilling and completion activities but does not permit any expansion, meaning actual gas and oil output can decline due to normal well depletion. Rising commodity prices incentivize creditors and debtors to resolve their differences and get back to production growth. As a result, some of the larger producers are expected to begin exiting bankruptcy more rapidly this summer and fall and in better shape than previously anticipated.
Much of course depends on individual circumstances and where these troubled companies have most of their production, with Permian and Eagle Ford-oriented producers in Texas looking among the best positioned. Bankrupt producers operating in higher-cost plays may not achieve the same leverage with creditors or the court. Some producers will still find that $50/bbl oil and $3 per thousand cubic feet gas still are not adequate to prompt activity beyond completing already-drilled wells.
One clear benefit of the oil and gas price run-up: bankrupt companies such as SandRidge, Linn Energy and others have ramped up their hedging in an effort to lock in prices and protect against volatility. The Bankruptcy Code allows firms in Chapter 11 to engage in activities comprising "the ordinary course of business," which for E&Ps typically includes risk management. In a June filing, SandRidge told the US Bankruptcy Court for the Southern District of Texas that it was more than doubling the volume of production it was hedging for the rest of 2016, from 40% to 84%. Linn -- the largest of the more than 80 E&Ps to file for bankruptcy since the start of 2015 (NGW May16'16) -- told the same court that it plans, "with an abundance of caution," to increase its gas and liquids hedging to capture the price upside.
Tom Haywood is editor of Natural Gas Week and Mark Davidson is Washington bureau chief at Energy Intelligence.