Overleveraged and under-capitalized, with cash flow at a trickle, many of Alberta’s gas producers are virtually in hibernation. So, when prices edged up in late spring, some management teams in this industry of eternal optimists proclaimed the commodity price “fix” was at hand. But what should investors — especially those regretting their decision to buy at the top of the market — think?

Conventional wisdom would hold that the collapse in North America’s drilling rig count, from a boom-time 1,800 down to 1,000 in late spring and 700 in early summer, plus repeated downgrading of new well forecasts, herald a price turn. These metrics have been solid leading indicators of reduced production and a price rebound. In June, natural gas prices bounced from less than $3 per thousand cubic feet to slightly more than $4. The optimists took heart.

But those who really dig into this stuff think the natural gas price fix will be longer and more complicated. The usual pricing prediction models no longer apply, because a game-changer has hit North America’s natural gas-producing sector — shale gas. This unconventional source, which is hard-to-reach gas trapped within airtight shale deposits, has single-handedly reversed years of declining U.S. production. Virtually unheard of a decade ago, shale gas now accounts for half of U.S. gas production, as well as for a small but fast-growing ratio of Canadian production.

Crucially, for the black art of price forecasting, these shale plays — big ones such as the Barnett in Texas and Fayetteville in Arkansas, plus numerous emerging ones such as British Columbia’s Montney and Horn River — are so unbelievably productive that they are driving continental gas deliverability with fewer rigs and fewer wells. While a conventional vertical gas well might yield production of 100,000 cubic feet to perhaps two million cubic feet per day, many of the horizontally drilled shale gas wells come onstream at five, 10 or even 15 million cubic feet per day. That’s the equivalent of 15 good, solid conventional gas wells in Alberta.

Investors who want to make sound decisions need to listen up to those who are really thinking through the implications. Alan Orr, an executive with Helmerich & Payne International Drilling Co., told a recent international drilling conference that there’s still a “blind assumption” that draws a “direct correlation” between the rig count and production.

Each horizontal shale gas-drilling rig is now equivalent to two or even three old-style vertical rigs: conventional thinking and ordinary metrics, therefore, need to go out the window. For example, despite that plunge in the overall rig count, as of early July there were still 380 horizontal wells drilling for natural gas in the U.S. For the first time, this was more than the number of vertical rigs, suggesting voluminous production gains.

In addition, stored gas is ready on a moment’s notice, making storage volume and rates of net injection or withdrawal key indicators of short-term pricing. After tracking within the five-year weekly average range through most of the winter, North American storage volume broke through the upper end in May, and the gap has been increasing. This is bearish for gas prices.

What will the “fix” require? Even more pain. First, a virtual cessation of conventional natural gas drilling, which will be especially punishing for Alberta. Second, a bottoming of the collapse in gas demand.

Still, there’s room for optimism. The deeper the slump, the more dramatic the recovery. Rebounding demand driven by low prices will at last collide with falling supply. The commodity price’s pyrotechnics — and investment returns — could be spectacular. IE



More of George Koch’s articles can be read on his weblog at www.drjandmrk.com.