Natural gas prices and stocks have held up better than I had expected. In trying to find out why, I found a couple analysts now indicating the economics that shale gas companies present in their financial statements is not as good as what they talk about in their press releases.

This would actually be bullish for natural gas prices and natural gas stocks. 

In other words, these gas companies allegedly talk the talk of cheap profitable gas in press releases but don’t walk the walk in showing it in their financials. Yet.

This newsletter has been part of the chorus that natural gas prices are going through a seismic shift downward because of the improved economics and technology behind horizontal drilling (HD) and multi-stage fracing (MSF).

I believe that the downturn in natural gas prices isn’t just cyclical because of the recession/depression and regular seasonal troughs; rather it’s a systemic issue. HD/MSF increases production per well dramatically, and opens up many new low-cost reservoirs, taking the marginal cost of natural gas down from $7.50/mcf to more like $4-5/mcf.

However, a couple prominent research firms have recently shown some data that could disprove this theory.

Ben Dell is the senior energy analyst at Bernstein Research in New York, one of the top sell-side research firms.  In a March 27 research note, he notes “a growing discrepancy between the internal rates of return (IRR) presented in corporate presentations and company reported ROACE (return on average capital employed)… For example, in many plays companies claim to generate IRR’s above 100% at $7.50/mcf gas or claim that their production is economical even at $2-3/mcf gas prices, but at the same time report 6-7% ROACE at a corporate level over the last 3 years, when the average gas price was $7.50/mcf.”

(Copyright doesn’t allow me to reprint or post it here, nor could I find it on the web.)

Titled “Why the Haynesville Won’t Work…at $4, $5, or $6/mcf gas”, Dell posits that companies are overstating production, understating costs, or there is a terminology gap at work.  For example, a producer could say the IP rate of a well (Initial Production) is 8 mmcf/d (million cubic feet per day). But was that a 30 day average, as is normal, or was it a 12 hour average just after coming online.  These HD wells can decline in production so rapidly sometimes that for stock promotion purposes, companies issue figures that may have been correct for a short time, but have no context and are not really “best practises” type numbers. 

Dell also questions if the all in costs of a well are being amortized properly into the economics that appear in a company’s press release.  If the cash operating cost of a well is $3/mcf, which is the number that appears in a release that does not include the $4-7 million it cost to buy the land and drill the hole – costs that Dell suggests basically doubles the breakeven level of the well to $6/mcf.  And to get an acceptable return – even to generate enough cash to drill the next well – would be $8/mcf.

 He told his readers how one operator in the Haynesville Shale in northern Louisiana (the most prolific shale play in North America) implied a greater than 100% IRR on a very large 14 mmcf/d well.  But once Dell started amortizing in some of his own estimated costs for land and drilling and taxes, that came down to a very pedestrian 14% IRR.

 I find that a very harsh set of economics, but his overall thesis could be valid. The cost inflation and land prices in the natural gas industry during the bull years of 2006-2008 meant many companies spent a fortune on a well before any production came out.

 A Canadian firm, Peters & Co. out of Calgary, echoed those thoughts this week with a brief commentary “Where is All the Cheap Gas?”

They ran some numbers on costs on companies operating in shale gas plays on both sides of the border – the FD&A, Finding, Development and Acquisition costs, and tried to adjust for currency differences. 

And what they came up with is that

• a) Costs in the US are only about $1/boe (barrel of oil equivalent) lower than in Canada
• b) costs have actually gone up slightly between the 1-year and 3-year average costs, over their universe of 33 companies.

When I look at the leading gas companies I know – Storm, Celtic, NuVista, Fairborne for example – all of them except Celtic had their costs go up, if only marginally.

What these two reports say is that, regardless of the reasons, the end fact is that as yet, lower cost gas is not showing up in the financial statements of the gas companies.

This would be quite bullish for natural gas prices and stocks.  Concludes Peters & Co: “the prediction that natural gas prices will be capped at US$6.00 per Mcf may prove to be a little premature.”

Natural gas stocks would appear to agree.