The Biggest Reason Natural Gas Prices Could Surge

Since mid-February, natural gas prices have risen by a whopping 30%, accelerating a trend of generally rising prices that began after April of last year.  

While much of this recent surge in prices reflects stronger-than-expected seasonal demand for gas, there's one huge reason prices could rise significantly over the longer term -- perhaps even triple over the next five years. Let's take a closer look.

U.S. natural gas market conditions
The recent increase in gas prices marks a departure from the weak pricing environment that has persisted over much of the past few years. As advances in drilling technologies allowed energy producers to coax massive quantities of natural gas from shale fields, an oversupply steadily built up, contributing to severely depressed prices for the fuel.

In response, virtually every major U.S. energy producer curtailed gas drilling in favor of producing oil and, to a lesser degree, natural gas liquids. For instance, Chesapeake Energy (NYSE: CHK  ) , the nation's second-largest natural gas producer, reduced its gas-directed rig count from over 100 rigs in early 2010 to around 10 by the third quarter of last year. Similarly, EXCO Resources (NYSE: XCO  ) slashed its gas rig count from 23 as of year-end 2011 to 7 as of the end of October last year.

But now, with gas prices above $4 per Mcf, some producers are either resuming or ramping up operations in gassier plays. For instance, Encana (NYSE: ECA  ) announced in February that it intends to increase its gas rig count in the Haynesville shale by three this year, citing the play's recently improved profitability.

Yet others -- including some of the lowest cost producers in the industry -- are waiting for prices to recover further before they rush back into gas drilling. For instance, Devon Energy (NYSE: DVN  ) , whose mainstay was once natural gas, said it doesn't plan on drilling for it at all this year. The company will instead be directing much of its capital budget toward drilling for liquids in the Permian Basin.

Not surprisingly, the number of rigs drilling for natural gas slipped to near a 14-year low last month. In fact, the current gas rig count is almost a fourth of what it was at its September 2008 peak.  

But give it another three to five years, and these companies may be flocking to gas fields in droves, eager to extract as much natural gas as possible. The reason? Sharply higher prices brought about by lower-than-expected supply and higher-than-anticipated demand for the clean-burning fuel.

Shale gas well decline rates
The reason future supply may turn out to be much lower than anticipated has to do with how quickly production from shale plays may taper off. According to Arthur Berman, a Houston-based petroleum geologist and prominent shale gas skeptic, U.S. shale gas wells have decline rates in the range of 30% to 40% per year, as compared with conventional wells that decline at rates between 20%-25%.

Berman has conducted exhaustive analyses of thousands of individual shale oil and gas wells and arrived at a shocking conclusion -- many shale plays have decline rates so staggeringly high that hundreds of new wells need to be brought online each year just to maintain a flat level of production.

In the Barnett shale, for instance, he calculates the yearly decline in total gas resources to be roughly 1.7 billion cubic feet per day. For net production in the play to increase, he estimates that Barnett producers would have to drill nearly 4,000 new wells each year.

High decline rates among shale gas wells may help explain why drilling is so abnormally sensitive to abrupt changes in gas prices. If wells continue to decline at the rates shale gas skeptics suggest they will, we could see a sharp increase in prices over coming years -- a response needed to give gas drillers incentive to produce more.  

Jeremy Grantham's view and final thoughts
Others outside the oil and gas industry have also suggested that natural gas prices could rise sharply in coming years. Investor Jeremy Grantham, co-founder and chief investment strategist at Boston-based investment firm GMO, suggests prices could triple over the next five years, as the current surplus gradually turns into a shortage.

Speaking at the Richard Ivey School of Business value investing conference in Toronto earlier this month, Grantham argued that the current level of US natural gas prices -- less than half what it is in Europe and about a quarter of the level in Japan -- is unsustainable.

This massive gap in global prices has lured a number of companies -- including petrochemical, steel, and fertilizer manufacturers -- back to the U.S., in hopes of capitalizing on cheap domestic energy. As these and other sources of demand grow, they will soon outpace supply and lead to a surge in prices, according to Grantham.

If prices do triple over the next five years, Chesapeake Energy, as the nation's second-largest gas producer, stands to benefit tremendously. Though the company has allocated the majority of its capital this year toward drilling in liquids-rich plays, natural gas still makes up more than three-quarters of the company's production mix. Will the company be able to ramp up oil production and survive until natural gas prices finally recover? Or will it languish under the weight of its heavy debt load? To answer that question and to learn more about Chesapeake and its enormous potential, you're invited to check out The Motley Fool's brand-new premium report on the company. Simply click here now to access your copy, and, as a bonus, you'll receive a full year of key updates and expert guidance as news continues to develop.