Natural gas prices will heat up again

Just two years ago everyone thought that America was running out of gas, says The Economist. But "all that has now changed". America is "drowning" in the stuff, according to natural-gas magnate Robert Hefner.

Recent advances in drilling technology have made gas in shale formations layered sedimentary rock far easier to tap. Drillers can now fan out horizontally, recovering gas from a larger area. Meanwhile, hydraulic fracturing, whereby rock is injected with water and chemicals to release the gas, has developed as a key technique. So potential drilling acreage has jumped sharply and official estimates of American gas reserves have soared. Indeed, according to this summer's estimate by the Potential Gas Committee, there is enough natural gas to supply America for 90 years at current consumption rates.

Along with the recession, the flow of new gas (production rose by 14% between early 2007 and mid-2008, for instance) has sent US gas prices to a seven-year low of around $3 per million British thermal units (MBTU). So the price record above $15 "will stand for a long, long time", says Lex in the FT. And after a slight recovery from this summer's lows, prices are edging down again. There is also concern over a weak recovery in industrial demand following last week's dire jobless figures. Inventories have increased at a record rate for six straight weeks, with storage sites at 97% of peak capacity, notes Bloomberg. "We need a cold winter" to alleviate the supply glut, says Carl Neill of Risk Management. But so far the weather has been unseasonably warm.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

That means prices could well fall further from their current level of around $4.5 MBTU in the short term. For next year, though, analysts are pencilling in a mild recovery. Production is "finally showing signs of weakening" and the inventory bounce should bolster demand, says Deutsche Bank. Barclays Capital expects prices to average $5 MBTU next year.

However, shale production is key to the outlook, and here the picture is murky. Not everyone is convinced that shale gas is set to revolutionise supply. Indeed, one sceptic, geologist Art Berman, says the excitement is reminiscent of the credit bubble: "in the midst of a boom or a bubble, it's hard to sit on the sidelines".

The question is how much can be extracted economically, and how fast. Berman thinks the industry is too optimistic about the lifetime production of shale wells. Initial rates of production are "fantastic", but judging by existing wells in the Barnett Shale in Texas, production drops off fast. With some, the drop-off is as much as 70% in the first year, with a further 20% decline in the second. This "hardly dovetails with the happy talk" about how shale gas will supply US energy requirements for decades, says Dailyreckoning.com. Berman also notes that "we are uncertain about how to apply decline models to newer shale plays because there is insufficient production history to satisfy all our questions".

Sanford Bernstein's Ben Dell is "respected on both sides of the debate", says John Dizard in the FT. He also points out that the average well "deteriorates more in quality", while more wells fail "than people believe". With the shale sector set to churn out less gas than expected, production could decline by up to 10% next year, reckons Dell. Prices may reach $8-$9 around $3 more than the futures market is anticipating. The London-listed ETFS Natural Gas (NGSP) tracks natural gas futures.