Making Sense of Demand vs. Supply, Key Factors Affecting Production

Dean Foreman
Posted October 7, 2021

The fundamentals of natural gas demand outpacing supply have driven prices to their highest for the season since 2008, and some analysts expect a natural gas supply crunch with potentially wide impacts this winter – including potential market tightening that could significantly affect household budgets and perhaps could risk physical hardship for some.

In such a context, many Americans may have a hard time figuring out what’s happening and how it affects them: If natural gas prices have soared, why hasn’t production risen more quickly to meet post-pandemic energy demand and moderate the conditions driving up costs? And another one: Why is the U.S. still exporting liquefied natural gas (LNG)? Three key points:

• Policy matters – The Biden administration’s policies have not inspired confidence – specifically that there will be access to energy reserves and that infrastructure will be built – needed by energy companies and investors as a predicate to ramped-up production. And an array of recent proposed government interventions could worsen the imbalance between supply and demand – and also threaten U.S. energy exports that have emerged as one of the great benefits of the energy revolution.
• Lingering effects of the pandemic recession – While there’s economic incentive to expand energy production, the gravity of the COVID-19 recession was large and remained difficult to shake. Given what has happened over the past year or so, many companies are taking great care before deciding to develop new wells and/or significantly increase production, if they have the physical and financial capacities to do so.
• Investment headwinds – Record-low capital investment and an anemic drilling response are due to financial, work force and supply-chain limitations. The industry also appears to have strived to live within its means and grow production efficiently, leveraging the inventory of wells drilled but not yet completed. Critical is the ability of many natural gas producers to cope with historically high debt levels so that they can invest and grow.

Striking is a razor’s-edge dichotomy – between two (false) narratives that a struggling industry is a poor investment or that in the current times it only cares about profits. What is true: Natural gas and oil remain essential to Americans’ everyday lives and economic prosperity.

Current market/price conditions underscore the need for smart energy policies that support domestic production while also fostering new technologies – so consumers can afford the energy transition.

Let’s delve into the details.

Tangible obstacles to drilling activity

Key factors include limited availability and increased costs for labor and materials, logistical issues and the continuing impact of COVID-19.

Materials – including steel, proppant/sand and water – are essential to develop hydraulically fractured wells that make up 95% of U.S. drilling in September 2021, per Baker Hughes.  Some specialized steel components and even basic items like storage tanks have been delayed and subject to volatile pricing.

Specifically, the input prices for natural gas and oil extraction increased by 97.2% year-on-year (y/y) – basically doubled – as of August 2021, per the U.S. Bureau of Labor Statistics (BLS). Manufactured steel components, which can contribute significantly in natural gas and oil developments, rose 68.3% y/y as of August. Consequently, the input costs that might be expected based on the past year have accelerated and compounded project cost uncertainties.

To maintain strong safety and operational integrity, drilling processes generally require proper staging and sequencing. Delivering materials to work sites depends on trucking and truck drivers, which have become scarce in serving many industries due to pandemic spurring retirements, slowing new driver training, and shifting many existing drivers into other jobs or economic sectors. 

COVID-19 infections have also disrupted some drilling and completion operations.  If a company cannot backfill workers quickly – and there apparently is limited availability of skilled workers in many areas – crews that may have been re-hired recently and need to get organized have in some cases been disbanded due to quarantines, soon after the crews were assembled. 

Some functions, such as hydraulic fracturing, must be done in a continuous manner to ensure the integrity of operations as natural gas begins to flow from a newly completed well.  Drilling and completions are also examples of activities where learning by doing things together can be an important ingredient to safety and productivity.

With the labor shortages and disruptions as well as a lack of predictability in materials’ delivery times and costs, some companies have remained hesitant if not financially unable to increase their activity levels until they have greater certainty.

Many of these post-pandemic challenges are not unique to natural gas producers but have recently been amplified by misperceptions about the current earnings landscape that, in turn, could bring about policy outcomes misaligned with U.S. economic and national security interests and objectives.  

Exercising capital discipline

Natural gas and oil industry investors have long clamored for capital discipline – companies to grow while living within their budgets. For many companies, capital discipline has meant using what they have at hand – leveraging their inventory of wells already drilled but not yet completed. 

With the energy sector’s occasional financial losses between 2015 and 2020, investors have demanded and increasingly rewarded restraint and measured risk-taking with higher share prices. The buzz words are capital discipline and delivering shareholder value – for example see here and here – and are likely contributing factors to the measured pace at which larger companies in particular have invested and drilled. 

But many companies have sustained if not expanded their natural gas and oil production this year by taking advantage of the inventory of wells that they previously drilled but did not complete with hydraulic fracturing and tying production into gathering systems.  The inventory of wells drilled but uncompleted (DUCs) as of August 2021 was estimated by the U.S. Energy Information Administration (EIA) to been drawn down by more than 35% y/y, but with more than 5,700 DUCs remaining. Some reasons why this inventory of DUCs exists have historically related to the:

• System by which companies lease prospective land and must develop it both to retain that land but also possibly count proved oil & natural gas reserves on this basis; and,
• Relative cost effectiveness of drilling during the 2020 downturn but waiting to complete the wells and consequently bring production to market until a later point when prices were no longer at extreme lows. 

The availability and relative cost effectiveness of adding production by completing an existing well, rather than drilling a new one, is therefore another contributor to recent weak drilling activity.

Caution driving restraint

For natural gas producers as a group, Bloomberg data suggest that reducing historically high debt – both in relation to the sector’s total capital and earnings – has remained a primary concern and likely driver of caution and restraint. The sector appears to recognize that it must use some portion of its capital to reduce its debt before investing and drilling for growth.

Drilling requires capital. And this capital must either come from existing cash flows or via the issuance of new debt or equity. If a company borrows too much, the interest expense to carry debt could affect their ability to invest as well as raise their future costs of debt and equity. 

We can monitor the U.S. natural gas sector using data compiled by Bloomberg and gauge its indebtedness by two metrics:  1) the share of total capital that debt represents, and 2) the ratio of net debt to earnings before interest, taxes, depreciation and amortization (EBITDA). 

Since 2005, the percentage of debt in total capital has generally risen – and increased the most during periods of relatively low natural gas prices, like 2012, 2015-2016 and 2020. With low interest rates, companies have had strong financial incentives to increase their debt, rather than issue new equity, but the shift from a norm of about 30% debt 16 years ago to more than 50% debt as of Q2 2021 is remarkable and historically been experienced by the sector only temporarily during the aforementioned 2015-2016 price downturn. 

The conventional wisdom is that it could become difficult for companies to borrow if their debt exceeds 60%, so reducing debt now that the ratio has recently exceeded 50% and risen could be imperative.  Furthermore, based on the ratio of net debt to EBIDTA, the sector’s ratio was almost always positive until the 2020 COVID-19 recession and reached unprecedented lows through early 2021.  

Consequently, there should be no question that most companies have needed to reduce their indebtedness and shore up their balance sheets before being able to invest and grow.

LNG exports: Snap policy reactions could be counterproductive

This is a particular concern for emerging U.S. natural gas net exports, which represented 13.5% of total U.S. dry gas production in August 2021 per EIA. At the very moment the natural gas and oil industry has demonstrated a modicum of recovery, it’s also become heavily scrutinized with proposed government interventions in energy markets.

Take for example: 1) the Biden administration’s recent call to examine gasoline prices, probably recognizing that such investigations have not identified systemic gouging of consumers in the past; 2) France freezing regulated natural gas prices; 3) some parties in Oklahoma proposing a ceiling on natural gas prices as utilities in the state and in Texas and tried to recover natural gas costs from this past winter’s storms from their ratepayers, with counterproductive results; and, 4) a blaming of LNG exports for higher domestic prices, including U.S. manufacturers calling for limits.

The razor’s edge therefore extends to potentially bringing misguided policy outcomes based on quick, even impulsive judgments. And policy uncertainty could affect the pace of investment as well as the ability of companies to advance large new capital project investments in the United States.

On LNG exports, it’s important to keep in mind that most LNG export terminals are multi-billion-dollar investments in the U.S. economy that largely motivated developments of incremental natural gas production as a prerequisite for investors to see them as viable investments. These investments and production, especially across the U.S. Gulf Coast, have spurred economic development and reinforced the strong impetus for U.S. drilling productivity, cost leadership and progress that has grounded the U.S. energy revolution.

It’s common for LNG sales and purchase agreements (SPAs) to include clauses for force majeure and potential supply curtailment. Historically, from an era when U.S. natural gas was in short supply, there was a right to emergency diversions of natural gas. Texas imposed such a restriction during the February 2021 winter storms to international buyers’ alarm. 

Ultimately, much more is at stake if energy policies scuttle the U.S. energy revolution, since the growing U.S. and global economies require even more energy today than they did before the revolution began – along with secure, reliable and resilient supply chains. Each of the proposed policy interventions directionally could reduce, rather than enhance, supplies and bring unintended consequences. 

With consumer affordability, home heating, and environmental progress of natural gas in power generation each hanging in the balance, it may take a relatively warm winter in coming months to avoid potentially brutal effects of some U.S. energy policies.