Several years ago energy investment banker Matt Simmons coined the term “production treadmill” to describe the current state of natural gas production in North America.  In simple terms, “production treadmill” describes the situation in which more wells must be drilled every year to keep production flat.  Today the treadmill is accelerating.  North American exploration and production companies (E&P’s) will drill a record number of natural gas wells this year only to see production fall.  To showcase the speed at which the natural gas production treadmill is now running, I will examine production statistics from four significant sources of natural gas in North America: Canada, Louisiana, Oklahoma and Texas.  These three states represent the largest producers of natural gas in the US. For the purposes of this exercise, I did not adjust the number of wells completed to account for natural gas produced from oil wells.

Canada’s Production Treadmill

Canadian natural gas production is now at a crossroads.  After years of very low prices due to a glut of production capacity and lack of export pipelines to the US, Canadian natural gas producers have enjoyed several years of record high prices.  Increased export capacity, which is the result of several new pipelines, has meant that Canadian producers no longer have to sell their gas at a significant discount to NYMEX prices.  This stronger pricing environment has also led to a massive increase in the number of natural gas wells drilled each year in Canada.

The above tables clearly display the difficulty Canada has had in growing its natural gas production.  However, the tables do not tell the whole story.

Canadian natural gas production would have experienced a more significant decline had it not been for the massive Ladyfern field in British Columbia.   From a standing start in 1999, the field reached its peak production of 665 million cubic feet a day (mmcfd) in March 2002 (Source: British Columbia Energy Ministry).  To put this into perspective, when Ladyfern was producing at its peak, it accounted for 10% of Canada’s total natural gas production.  Unfortunately, the party at Ladyfern is about to end.  With production down to about 150 mmcfd and dropping rapidly, it is estimated that Ladyfern will be totally depleted by the end of 2004. Ladyfern’s depletion will only speed up the Canadian treadmill as E&P’s will drill even more natural gas wells only to see production fall.

All hope for Canadian natural gas production is not lost.  The best kept secret in the Canadian oil patch is Canada’s massive deposits of coal bed methane (CBM).  While early estimates of total recoverable CBM reserves are very substantial, it is unlikely that CBM development will make up for declining production from conventional natural gas wells.  CBM currently constitutes less than 1% of total Canadian natural gas production and it will be years before CBM has a meaningful impact.

Louisiana’s Production Treadmill

The natural gas production treadmill in the second largest natural gas producing state in the US has been picking up speed.  Louisiana production ranks second only to Texas when Federal waters production figures are included.  While production remained relatively flat for most of the past decade, natural gas production is likely to have its first substantial drop off in 2003.  I make this prediction based on a couple of important data points.  Production numbers for the first five months of 2003 indicate that a significant natural gas production decline is likely in 2003.  Also, the number of wells completed in the last five years of the past decade was significantly higher than the number completed in the first half and production fell. 

The issue of petroleum prices often gets lost in discussions about a petroleum producing region’s decline curve.  I believe recent price data tells us a great deal about the potential of natural gas production in Louisiana.  When one considers that we are likely to average $5.50US per mmcf for all of 2003, a new annual record, Louisiana’s recent production troubles become even starker. If producers in the state are not compelled to significantly step up activity at today’s high prices, prices would have to more than double to stem Louisiana’s natural gas production decline. 

Oklahoma’s Production Treadmill

While Oklahoma is widely associated with America’s oil boom in the first half of the 20^th century, natural gas has also played a significant role in the state’s petroleum history.  As home to some of the US’s most prolific oil wells, the state attracted an incredible drilling rush during the early part of the 20^th century.  Oil production in the state peaked in 1927 at approximately 760,000 barrels a day and has been declining ever since.  Although it peaked much later, Oklahoma’s natural gas production has also been in a steady state of decline for the past decade. 

I was unable to locate data regarding natural gas well completions in the state of Oklahoma (I was only able to find a combined total of both oil and gas well completions).  I have chosen to provide several tables that clearly show that natural gas production is in a serious state of decline, despite an increasing number of wells.

Texas’ Production Treadmill

Many North America natural gas market observers, including your editor, view Texas natural gas production as a proxy for US natural gas production.   Since Texas produces approximately 30% of total US natural gas production, the largest percentage of any state, a look at the production numbers from the Texas Railroad Commission provides a great deal of insight into the US production treadmill.  While Texas natural gas production has been flat at 5.6 tcf per year, the number of natural gas wells needed to keep production flat has risen by nearly 30%.

What the Treadmill Means for Investors

Smart investors should recognize that North America’s natural gas treadmill is not going to slow down any time soon and should position their portfolios accordingly.  One of the best ways to profit from the treadmill is to purchase E&P firms that are able to buck the trend and increase their natural gas production in today’s challenging environment. 

The Canadian Dollar hits 9 ½ year High!

While many debate the reason the Bank of Canada decided not to lower rates at its mid-October confab, I applaud the move.  In an era when most central banks believe it is their duty to not let their home currency appreciate against the US dollar under any circumstance, David Dodge has taken the progressive approach of letting the Canadian dollar appreciate against that of its largest trading partner.  With Canada’s trade and budget surpluses, as well as its booming natural resource industries, look for the Canadian dollar to go to parity with the US dollar within the next four years.   One US dollar now buys only $1.32C of Canadian assets.

Why Bolivia is Important

On Saturday October 11^th, the streets of El Alto (a poor industrial city 10 miles outside of the capital city of La Paz) were filled with rioters angry over the decision made by the country’s leaders to export natural gas to Mexico and the US.  Bolivia’s gas was to be transported through Chile via pipeline and then liquefied and loaded onto LNG tankers.  The Associated Press reported that 16 people were killed in a weekend of clashes between Bolivia’s military and rioters. 

A great deal of anger towards the government’s plans to export natural gas is rooted in the belief that the revenues from the sales of natural gas exports will not benefit those at lower income levels.  By October 14^th, the violence had become so great that Bolivia’s army formed a protective ring around the presidential palace in La Paz.  That same day, President Lozada, wilting to the enormous pressure, announced plans to scrap the pipeline and search for other alternatives.  A couple of days later, President Lozada resigned.

While I do not expect recent events in Bolivia to repeat themselves in other natural gas exporting countries, I believe we will see increased popular involvement in how a country’s natural resource wealth is distributed.

Russia is an excellent example of a country that is likely to see civil unrest over its oil wealth.  When the country privatized its oil and gas industries, nearly all of the assets ended up in the hands of a few oligarchs.  These individuals are thought of as having rigged the system to gain control of the country’s petroleum wealth.  We are seeing growing disenchantment with the status quo by the average Russian citizen who is not participating in the country’s recent prosperity.  The politicians are listening.  In an effort to curry favor with the nation’s proletariat, President Putin commissioned the raiding of the offices of oil giant Yukos to find evidence of tax evasion and embezzlement.    Based on recent news reports, it appears they may have found what they were looking for.  Yukos chief executive Mikhail Khodorkovsky was arrested on October 25th and is being held pending investigation into charges of tax evasion and fraud.  It appears that this story gets only more political as

President Putin’s Chief of Staff, Alexander Voloshin, resigned on October 29th, in protest over Khodorkovsky’s arrest.

Despite protestations by its business leaders and politicians that Russia has adopted Western-style capitalism, the country is still a kleptocracy.  Now that Russia has once again coaxed major international oil companies into making big investments in the country, look for popular sentiment to turn violently against foreign involvement in the country’s oil patch. 

Editor’s Note

In addition to the new logo that is proudly displayed at the top of this month’s newsletter, we have put together a new website that has some great information on it. You can find it at www.canadianenergyviewpoint.com. I hope everyone enjoys the site and if you have any suggestions on how to improve it, please let me know.  Thanks.

© 2003 Bill Powers, Editor
Canadian Energy Viewpoint
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Information presented in this newsletter was obtained from sources believed to be reliable, but accuracy and completeness and opinions based on this information are not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein. The editor may have an interest in the companies mentioned. All data and information and opinions expressed are subject to change without notice.