There is a lot of confusion amongst investors – both retail and sophisticated institutional investors – about what the average break-even price is for natural gas producers in North America.
I interviewed a couple Calgary junior gas company management teams to understand this better.
I’ll try to simplify their industry lingo, and explain what some of the typical costs are for natural gas producers. After reading, I hope investors can:
- 1. understand the stages oil & gas go through from the wellhead to the end buyer
- 2. roughly what each of them costs in terms of per barrel of oil or mcf of gas
- 3. have an idea on what the breakeven price – of an average natural gas producer
- 4. hear who three low cost natural gas producers are
I’ve used a Canadian example but the system works much the same in the US.
After company ABC drills a successful gas well producing 1 million cubic feet per day (1 mmcf/d). That’s a thousand thousands, and the price for one thousand cubic feet (mcf) that day at the Edmonton gas terminal, AECO, is CAD$3.40.
The actual price the company receives is reduced by the distance they are from the AECO hub – the transportation discount. The quality of the gas also influences the price – higher heating content (i.e. more liquids in the gas) means they receive a higher price.
The gas from that well needs to get, at the end of the day, to the natural gas pipeline grid, which in Alberta is the Nova pipeline system. So Company ABC they must first build their own pipeline to connect their well to an intermediate-stage gathering system. That pipeline could be a few hundred meters or several kilometers, so that can be expensive. If ABC doesn’t own that gathering system, they must pay a fee to whoever owns it. Cost: $0.30 per mcf.
The gathering system is tied in to Nova at a meter station where Nova measures how much gas comes in to their system. Then it is transported on another pipeline (cost: $0.50 per mcf) to a plant to have the gas processed (to get the gas to pipeline spec – remove water, carbon dioxide, hydrogen sulfide etc. – cost: $0.90 per mcf) and to compress the gas to get it up to pipeline operating pressures.
Now the raw gas and its associated fuels have been refined so Company ABC can actually sell them to an end user.
But the actual buyer of the company’s gas is the “marketer” – the middle man. Gas marketers (such as Enron, SEM Canada, Plains, Tidal, Nexen Marketing, etc.) contract space on the Nova system and the large trunk lines (Alliance, TCPL, etc.) to get the gas to the end users (utilities, industrial users, etc.). Sometimes companies get to choose their gas marketer, but if their intermediate stage pipeline is owned by a marketer then they may be forced to use them.
Marketers get a reputation for getting the best gas price they can for Company ABC on a given day. Pricing varies, but it is based on AECO spot prices (see www.ngx.com). Each basin has its own spot prices, based on NYMEX with adjustments for transportation cost (to get the gas to New York) and currency exchange (in the case of AECO).
There can also be large price swings in different basins if the supply is too large for the physical export capacity on the pipelines – “trapped gas” – or the inverse also. That’s one reason you see the natural gas prices so low in the major gas producing areas of the Midwestern and Rocky Mountain states of the USA. There is a lot of gas fighting for pipeline space. NYMEX spot prices currently are about US$3.60, which is about C$4.50 but current AECO spot prices are $3.40, showing a $1.10 differential – that difference is the transportation for the cost per mcf to get the gas from Edmonton to New York.
Ok, so transportation and processing costs are now 30 + 90 + 50 = $1.70 per mcf – half of the wellhead price. What other costs are there? Royalties of course. Give Caesar his due. In Alberta this 1 mmcf/d well has a royalty of $0.70 per mcf, so Company ABC now has $1/mcf left. Company ABC’s operating cost to maintain their own well would likely be $0.20 per mcf, leaving them with about $0.80 netback, or profit per mcf.
Administration – G&A – and interest on debt could be as low as $0.50/mcf for a good producer (but many are more like $0.70/mcf). We are now down to $0.30/mcf cash flow.
The visual math is $3.40-(30+90+50+20+70+50)=$0.30/mcf cash flow. And we’re not done yet.
We have not yet factored the cost of exploring for and drilling the well. The industry calls this Finding, Development and Acquisition, or FD&A. After reading dozens of comparative analysis spreadsheets from various brokerage firms, I can tell you that best-of-breed natural gas producers have $2/mcf FD&A.
According to Calgary brokerage firm Peters & Co., only Storm Exploration (SEO-TSX) had finding costs under $2/mcf last year in their 34 company coverage universe, with little Berens Energy* (BEN-TSXV) right at $2 and Trilogy Energy Trust (TET.UN) at $2.01/mcf. The median was $3.29/mcf. (The low cost producers of any commodity have the best leverage when prices start to rise back to break even).
If you back in $2/mcf finding costs to the $0.30 cash flow (on $3.40/mcf gas) we hypothetically shown above, it intimates a $4.95 breakeven price for the lowest cost producers. We really need to bump that up by 30 cents as well, because on a higher realized gas price the royalties would be higher. We are now at CAD$5.25/mcf breakeven price for natural gas producers.
(Most analysts would argue that FD&A is the wrong number to use in calculating costs – the better number is a line item on the balance sheet that reads “Depletion, Depreciation and Accretion”. This is the cost to book proven reserves, and is a tougher test of costs. Only a handful of companies would have DD&A costs under $4/mcf - making the breakeven price CAD$7.25/mcf.)
This is a very simplistic version of a natural gas company’s cost structure, with conventional vertical wells. And it uses an example of an average sized well in the Western Canadian Sedimentary Basin; it is NOT an example of one of the big wells (10 mmcf/d ++) that comes from horizontal drilling.
Southwestern Energy in the US, a major gas producer, says that their large horizontal wells at their US shale operations do break even at US$3.60 gas – finding costs of $1.60 and operating costs of $2/mcf. They added that at current prices, drilling might be declining a bit but they see nobody shutting in production in the big US shale plays. Depending on the hub, natural gas is in the $3.20 range at NYMEX and under $3 in some interior hubs.
This illustrates that nobody is making money at these price levels. I paraphrase one quote I read on the web recently: At these low prices, it’s not a wonder that drilling for natural gas is down, it’s a wonder anybody is drilling at all.
*I own 15,000 shares of Berens Energy, BEN:TSX