Now to get to the juicy bits - the equations! There are two deterministic products you can derive from your data. I did similar work in an undergrad thesis for a complex system that seemed not directly controllable, yet when the empirical data was accumulated, graphed, time shifted to compensate for lag, out popped the relationships in;

1. Transfer function: as stated, this is a typical lagged feedback control loop. Using the standard controls systems engineering tools, you can determine the system response in the frequency domain. This will allow you to determine the system response due to set points and forcing functions. The break-even price is a definite set point that has a y=ax+b function over time y=$, a=constant in $/time, x=time, b=$.

2. Equation: P(price) = f(d,D,S,...) d=drilling rate, D=# drilling rigs, S=storage, etc. By performing a multiple regression analysis, you will derive a linear algebraic function with a degree of correlation (R). The higher the value of 0

Excellent presentation Jon. The best graphic representation of the realities of NG production I’ve ever seen. Not much to add other then some fine details on the dynamics you’ve described.

First, every drilling decision is based upon a pricing forecast of 10 years or so. Initial pricing is obviously based on present day well head prices. Escalation of the price over the course of the model is driven by pure optimism/pessimism. As you show so clearly there is a substantial time lag in expectations. Your analysis is quit sound but there has been a monumental shift in the dynamics in the last three years IMHO. I’m sure you are aware of the record setting NG rates we’ve the last 24 months or so. There is no mystery that the development of the unconventional NG plays was the cause of this growing deliverability. You’ve rightly pointed out the potential for even greater volatility in the NG market as a result of this rapid increase in NG supply. Ultimately the key element will be the relationship of the pricing model I mentioned above and the production characteristics of the UNG plays. To the best of my knowledge this relationship has never existed in the US NG business at such a significant level. Combining the high initial flow rate of a typical UNG well with the very near term price model has been, and will continue to be, the driving metric of future NG deliverability IMO. The revenue from the UNG wells more than 4 or 5 years out has become irrelevant to almost all operators. This is the more true with public companies. The increased initial flow rates of these wells have come at a high price. Thus the only way to generate a satisfactory rate of return is to recover the cost within the first 2 years or less of the well life. Declining production rates beyond that point, even in a good price environment, offer little incentive for drilling. This is vastly different then past NG exploration environments. Previously large discoveries made in conventional NG fields could generate significant cash flow 5 to 10 years into the future. Even offshore discoveries with their higher operational costs can generate significant net present value beyond Year 5. But that is not the future of NG development in the US today. The UNG plays are the future. Deep Water GOM NG may have some impact also (see below).

And thus, IMHO, we’re back to the defining limit of future UNG development programs: a two year price forecast. Though drilling costs will decline as rigs are stacked, companies will not reenter the UNG play until there is a clear sign of such price support. And even in the face of significant price increases I’m concerned we won’t see a very quick response for several reasons. First, there will be fewer players. In the next 12 months or so we will likely see a significant contraction in the number of players. Acquisition of the weak by the stronger will be the most likely mechanism. Second, companies won’t expand their efforts as quickly as we just witnessed IMO. The current price collapse has sent a shockwave through the industry it will not forget in just a few years. Third, I doubt the capital sources will be as free with their checkbooks as before. They won’t be forgetting their present sleepless nights either. A lot of capital was borrowed based upon $8 NG. Fourth, there will be a lot less equipment available and fewer experienced folks to run the operations. I forget the exact numbers but both the geological and engineering have grayed significantly. A disproportionally large percentage is within 5 to 8 years of retirement.

And one side note on Deep Water GOM NG production. By shear luck a significant amount of the NG production loss from hurricane damage was offset by the Independence Deep Water NG Hub coming online. I seem recall it quickly began delivering almost 1 BCG per day. As damaged production came back on line it added to the excess supply scenario you paint so well. But most here understand that as large as those Deep Water GOM reserves may be, technology now allows depletion at much higher rates then previously seen. I haven’t seen enough detailed numbers to quantify the decline vs. time relationship but it may well happen in the same time frame as the ultimate impact of the slow down in UNG drilling reaches the consumer. Combining that possibility with the worse case scenario of a couple of very high demand winter seasons and we may see a pricing spike/shortage situation on a scale never before seen in this country. Potentially a situation which might force Federal action. Whether such a response by our gov’t helps or hinders the situation is pure speculation at this point IMO.

Thank you Gail for all the good editing advice and doing the formatting.

You are right, with the credit unwind and companies vanishing faster and faster, it is hard to make any kind of prediction about when/if prices will rebound. It will be good to revisit this topic at the end of the summer and see the state of drilling and nat gas in storage.