The Economics Behind Oil and Gas Business Strategies

Leave a comment / Posted By syrup on July 22, 2012

How Nat Gas Producers are Beating Low Prices

As the country’s fortunes brighten, more oil and gas will be required to feed a recovery. While there’s a newfound abundance of both, the economics behind finding those resources and then delivering them are tricky.

Just what are the business strategies that go into such potential development? Every company, for instance, has an initial cost basis, or what they paid to acquire assets or leasehold interests. Most producers want to make at least a double-digit spread on their cost of capital. So, the profitable producers have both efficient operations and a low cost basis in their natural gas assets.

“If you pump $5 million into a oil or gas well, you ideally want to get that principal back with a return in a relatively quick period because of the decline curves associated with shale development,” says an industry source who asked that his name not be used.

He goes on to say that the economics behind each of the nation’s oil and gas basins vary. The Marcellus Region in the east, for example, is best known for shale gas plays and the natural gas liquids that spinoff from those searches, or ethane, propane and butane. The cost of that acreage has been high relative to the low price of the natural gas, although such lease prices are falling as some drillers pause.

That dynamic is giving the largest players such as Exxon a competitive advantage because they can hold their leases for decades and can afford to wait until the price of natural gas rises. Before the smaller players drill, they must factor in such issues as their capital and lease costs, as well as the price of the underlying commodity.

According to the U.S. Energy Information Administration, the United States has 862 trillion cubic feet of natural gas, which is second only to China. Here, unconventional shale gas has grown 48 percent a year from 2006 to 2010, making up a third of all natural gas supplies.

The gold mine, though, may now rest with natural gas liquids, which are more correlated to the high price of oil. Producers are therefore focusing on those shale gas plays that are rife with such liquids, says Valerie Wood, president of Energy Solutions in Madison, Wis. Conversely, she says that many producers are idling rigs in dryer gas basins.

“The price correlation between natural gas liquids and crude oil is changing a little but it is unlikely to cause a significant reduction in shale gas production,” says Wood, in a talk with this writer. “Eventually, the economics of natural gas liquids may cause a slow down in that area but we won’t see that for a while.”

More Pipelines

Wood also explains that some producers are moving from dry natural gas basins to crude oil regions where they are finding associated gas, although in some cases they are “flaring” that gas because there is no infrastructure to get it out. If they are able to capture the commodity that is found at shallower depths than oil, then the added supply will serve to keep prices temporarily low.

Indeed, the pure economics underscoring the natural gas and oil sectors are prompting some producers to shift their capital budgets to where they can find higher valued liquids, which includes those tied to natural gas and oil. To that end, one of the hottest oil plays in the country is now the Bakken field, which holds more than 5 billion barrels. As producers continue to shift gears and to seek out high-priced oil, natural gas supplies would diminish over time, increasing prices.

“We are focused on logistics more than commodity prices right now,” says the industry source, who notes that more “midstream” pipelines are needed to get the oil and gas out of the Bakken region in North Dakota and Montana. More long-distance interstate pipelines that traverse the whole nation are also necessary so that the crude oil has a pathway to Midwestern refineries.

For that to occur, the Interstate Natural Gas Association of America says that at least $200 billion in investment will be required over the next 25 years. The organization adds that the industry has been making substantial investments in new pipelines — something that it says will likely continue if federal regulators streamline their reviews. If the country does not rise to that challenge, the group adds that supply disruptions and price volatility would ensue.

Oil and gas producers here in the United States smell opportunity. But the sheer interest in holding acreage in shale gas fields has caused natural gas prices to sink. The winners will be those with low marginal production costs and efficient operations — and those who can skew their production toward liquid rich areas, whether those be natural gas spinoffs or oil.

EnergyBiz Insider is named a 2012 Finalist for Original Web Commentary presented by the American Society of Business Press Editors. The column is also the Winner of the 2011 Online Column category awarded by Media Industry News, MIN. Ken Silverstein has been named one of the Top Economics Journalists by Wall Street Economists.

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