Drilling data and producer announcements illustrate the rapid shift to liquids-rich plays, which have become a growing source of both gas and NGL supply. Companies, of course, are seeking natural gas liquids (NGLs) that currently fetch prices higher than natural gas, with gas production of secondary interest.

But market watchers worry that producers will glut the NGL market in the same way that gas production has boomed. NGL prices have held up so far, but worries remain. If NGLs prices fall, would it cut into gas supply?

We examine two cases to determine the attractiveness of liquids-rich drilling if the prices of NGLs slump. Since NGLs are often quoted in percent-of-oil terms, we examine the relative attractiveness of a liquids-rich well compared with a dry-gas well in a low oil price case such as $60 per barrel (bbl.) Please note that this price does not reflect a Barclays Capital forecast.

Then we test a drop in the value of NGLs relative to oil (from 50% to 25%). While the attractiveness of liquids-rich wells fades in these stress cases, they remain superior investments to dry-gas drilling. That is, NGL drilling, as well as the continued growth in gas supply from this subset of wells, is likely to continue.

Dry-gas drilling is so 2009, while liquids-targeted drilling is the hot trend. NGLs have fetched a higher price than natural gas, and the revenue contribution from NGLs can cover a substantial portion of the cost of a well and can greatly boost the revenue from a well. While natural gas production has grown 11% in the past two years, NGL production is up 15% over the same period.

The shift to liquids-targeted drilling began in earnest about a year and half ago, as shale gas producers discovered wet windows in new fields. While NGL production is nothing new, the focus on wet gas in shales is.

The real push has been to the Marcellus and Eagle Ford, and new plays with good liquids potential are emerging in both the U.S. and Canada. With natural gas prices languishing, but the value of NGLs holding, the revenue boost from NGLs has been a strategy worth pursuing. The value of NGLs has held more closely to oil prices than to natural gas.

Overwhelming the market

As more producers announced a shift to liquids-rich drilling, the market wondered whether producers would glut the NGL market as much as they had the natural gas market. Indeed, analysts were concerned that NGL production would begin overwhelming the market as early as this year.

The forward curve for NGLs was backwardated a year ago, reflecting partly this fear of over-supply and partly the lack of natural buyers in the deferred part of the curve. Sellers (producer hedging) simply outnumber buyers.

But prices for NGLs have not plummeted as some had feared. Indeed, prices for most NGLs, especially the heavier fractions that are linked more closely to refined product prices, have performed well despite growing production.

Prices in percent-of-West Texas Intermediate (WTI) terms are at or above recent historical levels for all NGLs except for a little price erosion in ethane. But even for ethane, the principal NGL produced in association with natural gas, prices have retained their strength in absolute terms, even if they have slid a bit in percent-of-WTI terms.

Calm before the storm

Is this NGL price strength simply the calm before the storm? Back to ethane, for example. While production has grown, so has the capacity of ethane crackers to process this feedstock. Conversations with market participants suggest that the expansion of ethylene production capacity, as well as the conversion of naphtha-fed plants to use ethane, is mostly behind us.

This growth in the capacity to crack ethane into ethylene has boosted the consumption of ethane, driven ethane inventories to a two-year low, and kept prices steady. But analysts suggest that the growth in ethane cracking capacity is mostly over for now. New plants have been proposed, but are years off. Thus, the market remains as concerned today, as it was a year ago, that ethane will soon be in oversupply. The forward curve for ethane remains backwardated.

In an earlier report, we calculated the gas price level at which dry-gas drilling provides the same return as liquids-rich drilling. In that analysis, we compared a typical dry-gas well with a typical liquids-rich well in a given play. Gas prices would need to be several dollars above current levels for a dry-gas well to equal the return opportunity of a liquids-rich well.

This led to three questions from clients. First, how would liquids-rich wells compare with dry-gas drilling if oil prices plunge (clients asked us to test $60 per bbl.)? Second, how would liquids-rich wells compare with dry-gas drilling if the value of NGLs relative to crude sank (from 50% to 25%)? Third, would either of these events diminish the attractiveness of liquids-rich drilling, thereby stalling natural gas supply growth from these types of wells?

We compared a liquids-rich Eagle Ford well with a dry-gas Haynesville well under different assumptions. We used, as a baseline, the current (August 8, 2011, close) five-year strip for oil (WTI at $89.50 per bbl.) and the current five-year strip for Henry Hub gas ($5.08 per million Btu, or MMBtu) and start with an assumption that NGLs sell at 50% of WTI. They have averaged 57% for the past month or so.

NGL prices in percent-of-WTI

With these oil and gas prices (and NGLs at 50% of WTI), gas prices would need to rise to $11.78 per MMBtu for a Haynesville dry-gas well to offer the same return as a liquids-rich Eagle Ford well.

Now assume that oil prices plunge. Although our oil colleagues believe that there is a price floor above this level, clients have asked us to run a $60 per bbl. crude oil price in our model, leaving the NGLs-WTI ratio unchanged at 50% and natural gas prices steady at the strip price of $5.08 per MMBtu. With these changes, the dry-gas well would outperform the liquids-rich well when gas prices are $7.98 or higher. Leaving all other factors the same (oil at $89.50, gas at $5.08), but dropping NGL prices to 25% of WTI, producers are indifferent between the two wells at a gas price of $9.48.

Even with a significant cut in oil prices or a drop in the value of NGLs, an Eagle Ford well would provide a better opportunity per dollar invested than a Haynesville well, unless gas prices climb above $8 per MMBtu. Even with a reduced price, NGLs add substantially to the value of the well.

Furthermore, since the Eagle Ford well produces natural gas also, its economics improve with rising gas prices. In other words, it is hard to envision a scenario in which oil or NGL drilling is not a better option for producers.

This suggests that liquids-rich drilling will remain a focus of producers as long as Eagle Ford-type wells are available and oil and NGLs prices are above the stress cases analyzed here. In other words, a drop in oil or NGL prices is unlikely to stall liquids-targeted drilling, and the natural gas that these wells produce should remain a growing component of supply.