There’s a bullish setup in natural gas

Gas and oil

Big picture, we prefer the more consumption-oriented commodities such as oil.  We’re not expecting outsized returns from oil; we just think the oil market’s going through a clearing process. High-cost, unconventional production in the US is already down a million barrels over a million barrels from its peak; we expect capacity to continue to be rationed out of that market. This will favour companies at the lower end of the cost curve as oil prices recover.

The big recovery opportunity, though, is natural gas. It’s been in a longer bear market than oil, primarily because producers in North America continued to drill while drilling for ‘dry gas’ peaked seven years ago.  North American producers continued to drill for oil until about 18 months ago, and there’s associated wet gas production from oil production.  So it took the collapse of the oil price to finally get supply rationing. 

Declining gas production

Now you’re getting an acceleration [in production decline]. Unconventional gas is the opposite of LNG; with LNG you sink 30 billion dollars into a terminal, and you’ve got an asset that produces as an annuity for 20 or more years.  With an unconventional oil well, drilling costs are roughly $14 million, (that’s why lots of small guys can do it) but from peak flow rate, within two years you’ll be down 60%. So you can expect to see that kind of decline rate in oil and gas.

So decline rates accelerate, we think the underlying decline rate is around 22%. We’re down just over a percent year-on-year, so it gets pretty interesting in 18 months’ time.

Competitive US market

Gas in the US is so competitive; it’s replacing coal for power generation, it’s being exported it to Mexico, it’s competitive against Australian north-west shelf producers, and even against Russian gas going to Europe. Those two competitors are using oil-linked gas prices, and that relationship tends to be 6 to 1 - so $60 oil, $10 gas. At $2.50, gas in North America it’s a no brainer to export.

We’re expecting a big bull market in gas. It has to recover to the marginal cost of production, which we think is around $4.50.

Transcript  has been edited for clarity.