Frackers need bankruptcies

Krim Delko
Aug 26, 2017 · 3 min read

Natural gas plagued by too much supply and lack of demand growth

There are too many producers of natural gas drilling for survival in onshore US. Natural gas prices are low because supply is growing faster than demand. Exports cannot pick up the slack. The only way to stop this is through consolidation with given the high debt load of many frackers means bankruptcies.

The picture in US natural gas is best explained the story of Range Resources, the Marcellus producer and one of the largest US based natural gas companies. Range discovered the Marcellus shale around 2004. Since then the company has grown production and reserves massively. According to the EIA the Marcellus shale alone has about 75% of the natural gas reserves of Norway. The whole of Pennsylvania is around where Norway is.

Range and EQT share the lion’s share of the market in the Marcellus. Most recently Range has been growing production around 22% annual since 2014. Nevertheless the stock is down 80% from the highs. How can that be?

The answer is low natural gas prices and growing supply. The supply is coming from tow sources. One is the natgas producers like Range themselves and the other is shale oil players, particularly the prolific producers in the Permian basin in Texas. The Permian seems to be a growing problem since producers have discovered that associated gas levels (that is gas pumped in conjunction with oil) are much higher than expected. In other words, if oil prices stay around 50$ or higher there will be much more oil production coming out of the Permian and hence more gas with it.

Now, supply is not the only problem. Demand isn’t growing enough, either. You would think that with lower natgas prices demand will pick up. It is picking up, but not enough. According to the EIA natgas consumption for electricity, which is about 35% of total natgas consumption, is expected to grow in the coming years, but not enough. First, electricity consumption is not growing at all and second gas turbines are becoming more efficient, i.e. there is less gas needed to produce the same amount of energy.

Perversely, Coal turbines are not more efficient and with low coal prices, coal demand has grown and is gaining share again versus gas.

According to this picture natgas producers are caught between a rock and a hard place. Demand isn’t growing enough and supply is growing too much.

Producers hope that demand will catch up. But residential (15% of total demand) and industrial (30%) are not growing at all. People don’t need more gas even if it’s cheaper. Gas was expected to gain share versus oil in the petrochemical complex, but that doesn’t seem to bite yet.

What else can producers hope for? One is electric cars. But interestingly enough when talking to producers they seem lukewarm towards EVs. The reason might be that if EV’s pick up it will happen in conjunction with renewables which are gaining share versus gas and coal in the electricity market. It is not conceivable that renewables will gain enough share to endanger gas in the near future but with battery technology getting better it’s possible that renewables will gain more share in the future.

The only real hope for companies like Range Resources is a J curve. That means first it has to get worse and then it can get better. There has to be a wave of bankruptcies followed by consolidation. Less companies but financially more healthy should control the US natgas assets, so they can adapt supply to demand and hence run a profitable business.

The reason that is not happening is that the highyield bondmarket has been financing most of the natgas complex and the market is hanging on to its investment. They don’t want to let go and create bankruptcies.

Two scenarios for improvement in the natgas space:

  1. Bond market crash. In this case the bond market crashes because of other reasons and brings down with it the natgas drillers. Consolidation will follow and a healthier sector can emerge.
  2. Bond market gives up. In this scenario the natgas players drill themselves into oblivion and the bond players give up on the weakest. For this scenario to happen the bid-ask price of bonds has to narrow. That means that the spread between what the bondholders want and what potential buyers are willing to pay has to narrow. Currently it’s too wide.

We estimate that with another 30% correction in stocks scenario 2 will happen.

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Krim Delko

Written by

Investor, writer, sky runner and Brazilian JiuJitsu.Father of one.

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