Familiar Ground

Articles in two recent investment newsletters reminded me once again how volatile the prices of oil and natural gas can be and how many factors are continually in play to move markets, sometimes dramatically.  Price volatility makes investment planning and project analyses difficult, and can create havoc with investment results over both short and longer terms.

Several years ago, Morgan Stanley issued a report of the relative volatility of all traded commodities, listing oil and natural gas the most volatile of all.  I have not seen a recent update of the statistics, but I would not be surprised to learn that the two continue to top the list.

The June 18, 2012, issue of U.S. Research, produced by Raymond James, discusses future crude oil markets and projects rocky days ahead.  Only four months ago, the publication substantially cut its 2013 oil forecast due to concerns about a rapidly growing U.S. oil supply and a deteriorating outlook for global oil demand growth. In a recent report, U.S. Report lowered its 2013 West Texas Intermediate (“WTI”) price projection to $65 per barrel (down from $83).  The new oil price forecast is well below the WTI futures strip at $85 per barrel and the street consensus at $110 per barrel.  Also lowered was the long-term (10-year) WTI forecast to $80 per barrel.

Goldman Sachs issued its Equity Research Report on the great Marcellus Shale expansion on July 8, 2012, discussing U.S. natural gas prices in depth.  Summarizing its natural gas price estimates for 2013, they “believe 2013 natural gas prices are likely to surprise to the upside versus the current strip as a greater gas rig count will be needed once storage moves to more normal levels, assuming continued low range bound prices for the rest of 2012.” Goldman Sachs believes demand and takeaway constraints warrant ‘price sensitive growth’ for Marcellus development to be in the $4.00 to $4.50 range.

“Getting it wrong” can be costly.  Oil and gas operators who drill wells with a reasonable assumption of a future product price range face capital losses if prices drop below their projected break-even point.  Producers who are well capitalized, have little or no debt, and with substantial current production that can be hedged are the most able to weather periods of low prices.  Producers with high cost structures and weak balance sheets are especially vulnerable to market weakness.

Timing of sales of production may be a major problem in many of the new areas of development.  Many of these are in previously unproven territory–areas with few existing wells to provide good analog data to assess the risk of new exploratory wells and inadequate takeaway infrastructure to provide good markets.  It is a chicken and egg conundrum.  New wells must be drilled and tested before the cost of pipeline construction can be judged as attractive.  Yet expensive, newly completed wells must remain “shut-in” until new facilities are planned and constructed. Because of cost of capital, otherwise economic wells may become non-economic if they remain shut-in for an extended period.

Exacerbating the problem is that many states no longer allow “associated gas”— that which is dissolved in oil in the producing formation and is produced with it–to be flared or vented. These states require that gas must be transported by pipeline to points of sale or use in order for oil to be produced and sold.  In other words, connections to natural gas pipelines are needed as soon as possible after wells are completed. Thus, financing construction of natural gas gathering and transporting systems is a primary investment target for Five States.

Even where adequate infrastructure and markets exist, events may have negative effects on wellhead prices.  Punitive governmental policies and regulations, weaker domestic and foreign economies, shortages of drilling and completion supplies and equipment, unseasonably mild weather, and increased competitive factors can all diminish profits.

We at Five States spend much of our staff time discussing current conditions and possible future events which could impact our business.  Fortunately, as has been discussed in previous issues of The Producer, hedging has become a major risk mitigation strategy of Five States. Tom Costantino, our chief hedging tactician, brings more than 20 years of knowledge and experience as an institutional commodities trader.  We are delighted to have Tom aboard to help us.  Having weathered several previous business cycles, all of us are very aware of the deleterious consequences of poor planning, lack of foresight or bad decisions, and we remain focused on our business plan of making money for our investors while building an inventory of long life, high quality producing oil and gas interests.

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