2011 Energy Surprise: Oil Price Down and Natural Gas Up!

This morning the business talk shows focused on crude oil futures price climbing above $92 per barrel.  The talking heads are commenting on the oil price move being part of a upward trend that will soon break the $100 a barrel price barrier last experienced in 2008 – both on the way up to $147 and during the following commodity price collapse.  The $100 a barrel mark rapidly has become the conventional wisdom for 2011’s forecasted price, driven largely by the view that China’s economic growth and insatiable demand for oil will fuel the push.  

John Tierney of The New York Times wrote a column last week about a bet he had made in 2005 with the late Houston energy investment banker, Matt Simmons, over whether oil prices would average $200 a barrel in 2010.  Obviously, Mr. Tierney won the $5,000 bet as oil averaged somewhere in the $77 a barrel range.  But as he wrote, his reasoning behind his bet against Mr. Simmons’ and the other peak oil theorists’ views was because he believes in the ingenuity of humans.  For him, that means the ability to find and develop greater oil supplies along with perfecting greater efficiency in using that oil, both of which would combine to mitigate any sustained long-term surge in oil prices.  In mid 2008, people would have been advising Mr. Tierney to get his checkbook out, but the second half of 2008 changed the momentum.  What we have learned is that free markets do respond to price signals – oil supply is higher and demand, at least in the developed world is lower. 

On the supply side we continue to get good news, not surprising given the higher oil prices.  New discoveries off West Africa and Brazil reflect that development.  Today’s Houston Chronicle carries a story about new, sharply higher estimates for the volume of oil contained in the North Dakota Bakken shale formation and the increased output of new wells being drilled there.  The surge in drilling activity in that formation assures higher production for the next year or more with the potential it could be substantially higher in three to five years. 

Natural gas is another story.  The revolution in shale gas exploitation has shifted America from a land of gas shortages to one of plentiful supply.  The U.S. Energy Information Administration recently confirmed the outlook for gas reserves first set forth by the Potential Gas Committee in 2009 that the U.S. had years of natural gas supply – at least at current rates of consumption.  Exactly how many years of additional supply remains debatable with the critical issue being the gas price that will make drilling and producing gas economical.  Most expectations call for gas supply, driven by the drilling boom resulting from the “land grab” for acreage positions that necessitates drilling producing wells to hold the leases, to continue to surge.  Until there is a meaningful upturn in natural gas consumption from either new power plants or industrial use, the question will remain: When will newly drilled gas wells begin to fall-off? 

The October 2010 EIA data on gas production taken from its Form 914 survey of producers shows the first hint that the shift in drilling away from dry natural gas wells and toward wells with higher crude oil and liquids content in the gas stream may soon have an impact on the volume of new gas production added.  The number of sales of gas shale acreage could also signal the early signs of “economic rationalization” beginning to come to play in the gas market.  

The conventional view is that gas prices will languish in the $4-$5 per thousand cubic feet range not only for the balance of 2011 but also for the next few years.  The last time the industry experienced an extended period of low gas prices (the late 1980s and early 1990s), the use of gas was restricted by the government.  We no longer have those constraints.  In fact, we have governments working on energy policies that would increase demand for natural gas, something we worry about long-term. 

As they say on Wall Street, the prospect of meaningfully higher oil prices and lower gas prices are crowed trades.  That means those positions reflect the conventional wisdom.  There are many reasons to support the conventional view, but there are some hints of changes in the oil and natural gas markets that could provide a surprise to those embracing the conventional view about prices in 2011.