JANUARY 26,2012

ENERGY REVIEW

The Diapason Capital Markets Report

Chart of the Week: High oil price shift rigs from Gas

Key economic data this week

FHFA house price index highest since 2005 Dec pending home soften slightly, still firm Dec existing home sales still trending higher FOMC extends low rate guidance till 2014 Initial claims plummet the most since 2005 Eurozone flash PMIs surprise to the upside German IFO survey rise for third month straight Belgian business confidence rise a second month

Is the Natural Gas rebound sustainable? Perhaps not yet at this time

Natural gas prices hit their lowest price levels since 2002 during the current decline at $2.289 in the March contract but has recovered by as much a 18.5% since Monday after Chesapeake Energy Corporation (the US second largest natural gas producer) said it will reduce dry gas drilling activity and production with immediate effect. The price reversal looks dramatic, but what can we reasonably expect for natural gas prices development from here? The answer is not straight-forward, but net-net, Chesapeake's cutbacks is a very good start, and this may indeed the beginning of a stability for natural gas, but much more has to be done by producers to prevent prices from sliding further. There remains no clue as to when balance will be back in this market, so there are other good reasons to be cautious about the recent large rebound in prices in the U.S. We do not believe that we have seen the bottom in gas prices this year. Stabilization, yes, but absolute trough -- perhaps not yet. Conditions for gas investment may be better by mid-year. Other companies may announced drilling cuts in the coming months if prices do not rebound to more healthy levels (around $4 per million Btu). Encana, the U.S. fifth largest producer, is likely to be the next to announce drilling cuts.

For important Disclaimers and Disclosures, please refer to the last two pages of this publication

JANUARY 26,2012

E N E N E R GR E R E E WE W ERGY Y VIVI

The Diapason Capital Markets Report

Is the Natural Gas rebound sustainable? Perhaps not yet . . .

Further cuts and new regulations may however balance the market sometime in H2 2012
By Robert Balan and Alessandro Gelli
Natural gas prices hit their lowest price levels since 2002 during the current decline at $2.289 in the March contract but has recovered by as much a 18.5% since Monday after Chesapeake Energy Corporation (the US second largest natural gas producer) said it will reduce dry gas drilling activity and production with immediate effect. The price reversal looks dramatic, but what can we reasonably expect for natural gas prices development from here? The answer is not straight-forward, but net-net, Chesapeake's cutbacks is a very good start, and this may indeed the beginning of a stabilization process for natural gas, but much more has to be done by producers to prevent prices from sliding further. We hope to explore in this report the avenues open to producers in defending gas prices. The obvious rationale for lower natural gas prices is an oversupply in the U.S. As supply exceeds demand for natural gas, prices are pushed lower as the market swings in favor of gas buyers. Nonetheless, there will be a time when production will get reduced to the demand level that will improve the market prices for natural gas. What also complicates the issue is that this high production growth comes amid weak demand. The uncertainty is the timing of the supply-demand correction, but we hope to draw a timeline which could help pinpoint the likely period when market balance returns. Chesapeake ready to cut production by up to 1.0 bln cubit ft Chesapeake Energy Corp. (the US second largest natural gas producer), one of the oil and gas producers at the origin of the current natural gas supply glut, said it will reduce drilling activity this year by approximately 50 percent and will cut 8 percent of its production (0.5 billion cubic feet/day)-- while gas-well completions will be deferred as much as possible. After drilling more U.S. gas wells in recent years than any other company, Chesapeake, based in Oklahoma City, announced it was cutting capital spending as natural gas prices had unexpectedly reached its lowest levels in a decade. "An exceptionally mild winter to
For important Disclaimers and Disclosures, please refer to the last two pages of this publication

US Rigs Count by Type

2'500 70%

Vertical Rigs (lhs) Directional Rigs (lhs) Horizontal Rigs (lhs) Share of Horizontal Rigs (rhs)
2'000

Sources: Diapason, Baker Hugues

60%

50%

1'500

40%

1'000

30%

20% 500 10%

0 Jan-01

0% Nov-01 Sep-02 Jul-03 May-04 Mar-05 Jan-06 Nov-06 Sep-07 Jul-08 May-09 Mar-10 Jan-11 Nov-11

JANUARY 26,2012

E N E N E R GR E R E E WE W ERGY Y VIVI

The Diapason Capital Markets Report

Is the Natural Gas rebound sustainable? Perhaps not yet . . .

date has pressured U.S. natural gas prices to levels below our prior expectations and below levels that are economically attractive for developing dry gas plays in the U.S., shale or otherwise," said CHK Chief Executive Aubrey K. McClendon. Chesapeake also said that it is prepared to double the reduction of its production to as much as 1.0 billion cubic feet per day. Natural gas prices jumped after the announcement, with the market hoping that this message will resonate with other natural gas produces who may decide to cut production as well. Eventually, if gas production is reduced across the producers, the price of natural gas will recover. For now that remains a mere hope. But the market has been taking some of its cue from a repricing which happened in September 2009, when natural gas prices soared from circa $2.40 in the front month to well above $6.00 by late January 2010. The Sept 2009 gains however were initially triggered by other factors which only have superficial resemblance to the current conditions. It was sparked mainly by the Energy Departments weekly data that showed a smaller-thanforecast increase in U.S. stockpiles. Though the news did not really change the overall supply and demand picture then, it did send traders scrambling to buy back previously sold positions. Not too long after, a colder than usual winter season pushed prices almost three-times fold at its peak on January 2010. Gas producers may have to wait for a while before getting that kind of relief. Problem of gas producers benefitting industry Chesapeake Energy Corp. was not the first to curtail production. Earlier, small gas producer EQT also announced it is shutting down its production line in the Huron natural gas basin. Production shutdowns from EQT and Chesapeake include wells in the Appalachia region where drilling is most economic for drillers, reflecting easier and cheaper production costs.

lower natgas prices means contribution to economic growth. The petrochemical and plastics industry benefitted from the low prices. Access to lower-cost natural gas liquids feedstocks has boosted export competitiveness in products such as ethylene and polyethylene. European producers, in contrast, which rely on heavier crude oil-based feedstocks such as naphtha and vacuum gas oil, continue to see a feedstock cost disadvantage.

The fact is low natural gas prices is providing a huge tailwind to the U.S. economy right now. The glut means new industries which would hire, and users of gas have big economic advantages over competitors in other countries. The U.S. could stay a manufacturing powerhouse: low prices on key inputs mean competitive The travails of the producers are, of course, benefitting other segments of the exports, and exports growth means jobs created. How long this economy. Pipeline constraints in some areas may keep some household con- industry-friendly conditions will last is hard to fathom at this time. sumers from seeing lower natgas prices in their bills, but for industrial users of Given that demand for natural gas in the U.S. is rather somewhat gas these are heady days. The glut can be worked off, but meantime, the inelastic (at least until theres some kind of initiative to have more
For important Disclaimers and Disclosures, please refer to the last two pages of this publication

JANUARY 26,2012

E N E N E R GR E R E E WE W ERGY Y VIVI

The Diapason Capital Markets Report

Is the Natural Gas rebound sustainable? Perhaps not yet . . .

industries using it), focus has to continue on the production and storage figures. There remains no clue as to when market balance will be back, so there are good reasons to be cautious about the recent large rebound in prices in the U.S. At this point, we do not believe that we have seen the bottom in natgas prices this year. Stabilization, yes, but absolute trough -- perhaps not yet. To show why it is so, requires a broader perspective on the natural gas market. The culprits for low natural gas prices are strong production growth amid weakening demand because of relatively warm weather. Actually the warm weather did not affect the US alone: since the end of October 2011, UK natural gas prices (the only other pure market-driven natural gas price) fell by 18% because of warmer than normal temperature. Likewise, US natural gas prices fell by 35%, driven by strong production growth. Indeed, according to preliminary data from the EIA, US dry natural gas production grew by 4.5 bcf/d y/y in 2011, the largest annual increase ever recorded. US natural gas production has outpaced the previous production levels record high of 1973. There is a shift to oil and liquids from gas Strong production growth amid declining natural gas prices is the result of the confluence of several factors. First, some companies needed to drill to hold on to gas property leases) acquired before the price collapse in 2008. Usually companies have 3-4 years to drill before losing the lease. Furthermore, strong cash flows from M&A activity driven in big part by foreign entities contributed to funding of a multitude of projects. According to Ernst & Young, shale gas and oil dominated the largest M&A transactions: BHP Billiton's acquisition of Petrohawk Energy for $15 bn, Marathon Oil's acquisition of Hilcorp Resources' Eagle Ford shale properties for $3.5 bn and Noble Energy's purchase of 50% of Consol Energy's undeveloped Marchellus shale acreage for $4.1 bn. These transactions account for a large share of the $76.0 bn in total upstream deal value in the US for 2011, slightly down from $77.2 bn in 2010. However, relative to 2010, there is now a qualitative shift in M&A acquisitions toward plays with more oil and liquids, because of the larger spread between
For important Disclaimers and Disclosures, please refer to the last two pages of this publication
Billion Cubic Feet per Day

US and UK Natural Gas Futures Price 2010-2011

$12

UK Nat Gas Futures Price

$10

US Nat Gas Futures Price

Dollars per Million Btu

$8

$6

$4

$2

Sources: Diapason, EIA

$0 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12

U.S. Dry Natural Gas Production 1900-2011

70

Sources: Diapason, EIA

60

50

40

30

20

10

00

12

32

44

76

24

56

88

00

16

36

48

68

80

19

19

19

19

19

19

19

19

19

19

19

92

19

19

19

19

19

19

20

20

19

19

19

19

19

19

19

19

20

08

08

20

28

40

60

64

52

72

84

04

96

04

JANUARY 26,2012

E N E N E R GR E R E E WE W ERGY Y VIVI

The Diapason Capital Markets Report

Is the Natural Gas rebound sustainable? Perhaps not yet . . .

oil and gas prices. Moreover, the US shale oil success has proven to be a more profitable working model to replicate for foreigners because of the lower amount of infrastructure needed (oil can easily be transported by trains, trucks or barges, while gas needs to be processed and transported by pipeline to customers or LNG terminals) and the higher value of oil relative to gas. The large spread between oil and gas prices has therefore prompted gas producers to increase their oil exposure at the expense of gas. Still, the move towards liquid-rich and oil plays reduce natural gas production growth by only so much as associated gas will still be produced. A well could earn around $4.3 per million Btu by producing 40% of oil and 60% of gas (using WTI oil price as benchmark because the oil produced is usually very light and sweet). Higher oil prices exacerbate the gas glut the US government, specifically to President Barack Obama. Pres. Obamas fracking play The Obama's State of the Union Address has reflected concerns of hydraulic fracturing on the environment as he asked all companies to disclose the chemicals they use. Furthermore, he said that "America will develop this resource [natural gas] without putting the health and safety of our citizens at risk", suggesting that further regulations on hydraulic fracturing could be implemented. This approach has been supported by the Environmental Protection Agency (EPA) for some time.

In December, the EPA released a draft over findings of aquifer contamination by hydraulic fracturing operations. The final report Thus, high oil prices also contribute to higher natural gas production, by mak- will be completed in 2014, while preliminary results will be ing profitable gas wells which produce a certain amount of liquids. This also explains why the Eagle Ford Shale in South Texas is the most popular shale as US Natural Gas Inventories 4500 the oil price there would be closer to Brent price than WTI (which could had US Natural Gas Inventories $0.3 per Million Btu to a 40/60 oil/gas mix). Chesapeake clearly said that it will 4000 stop drilling activity only on dry gas projects, meaning wells that produce none 3500 or a negligible amount of oil (as opposed of wet gas which has high liquids content), while drilling for wet or liquid-rich wells will continue.
3000

Other companies may announced drilling cuts in the coming months if prices do not rebound to more healthy levels (around $4 per million Btu). Encana, the US' fifth largest gas producers, encountered difficulties last year because of its high exposition to dry natural gas, forcing the CEO to announce plans to move to oil and liquids-rich areas, while the company used to be proud to be called a "pure" gas player. This company, which still have important assets in dry gas areas, is likely to be the next big producers to announce drilling cuts. Price fundamentals on the short run improved for natural gas because of the announced production cuts. However, the situation remains depressed because of the weak demand. Nevertheless, the situation could change soon, thanks to
For important Disclaimers and Disclosures, please refer to the last two pages of this publication

B illion C ubic Feet

2500 2000 1500 1000 500

Sources: Diapason, EIA

0 Dec-09 Aug-10 Apr-11 Dec-11

JANUARY 26,2012

E N E N E R GR E R E E WE W ERGY Y VIVI

The Diapason Capital Markets Report

Is the Natural Gas rebound sustainable? Perhaps not yet . . .

published in 2012. The early release of the draft was clearly a way to head off objections to the proposed rules. The adopted timeline suggests to us that the EPA is building a case against hydraulic fracturing. A moratorium on hydraulic fracturing would have a significant impact on oil and gas projects. According to a IHS Global Insights report in 2009, the elimination of hydraulic fracturing would lead to a 45% decline in natural gas production by 2014 relative to the reference case (no change in policy), while fluid restrictions would decrease natural gas production by 22% during the same period. Because of the rapid development of fracking since 2009, these figures could be raised. Now almost 60 percent of oil and gas fields use horizontal drilling which usually goes hand in hand with fracking. EPA regulations will impact natgas prices Furthermore, new regulations from the EPA are likely to have an impact on natural gas demand. The final standards for emissions standards for power plants were released in December. This rule referred to as the utility Maximum Achievable Control Technology (MACT) rule is likely to harm the profitability of heavy polluters such as coal-fired power plants, while clean gas-fired plants are likely to benefit from this rule. According to Crdit Suisse, about 60 GW of coal capacity (17.6% of total nameplate capacity) will be closed between 2013 and 2017 in response to EPA rules. Furthermore, another 100 GW will require a significant amount of investments to meet EPA emission rules. The first plants to close will be the older ones: 33% of the US coal plants (112 GW) is over 40 years old and 70% (238 GW) is over 30 years old. Thus, natural gas-fired power plants could gain in two ways: It would first replace the retired coal-fired plants and could also play an important role during the retrofitting period. Indeed, it is extremely easy for gas-fired plants to change output rapidly, while solar, wind and nuclear plants have little flexibility in controlling output. Thus, gas-fired plants could easily boost output while nearby coal-fired plants are installing environmental controls systems. Between 2012 and 2017, US natural gas demand is expected to gain between 4.9 bcf/d and 10.1 bcf/d (+7-15% of US gas consumption) from the implementation of
For important Disclaimers and Disclosures, please refer to the last two pages of this publication

12-month rolling US Power Generation by Sources

400'000 58%

Sources: Diapason, EIA

350'000 56%

300'000 Million Kilowatt-hours

54%

52% 250'000 50% 200'000 48% 150'000 46% 100'000

44%

Coal (lhs)
50'000

Natural Gas (lhs) Nuclear (lhs) Share of Coal (rhs)

40% 42%

Other Fossil Fuel (lhs) Renewables (lhs)

0 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

these new regulations. The higher impact on demand will probably begin by mid-2012. This is when we believe market balance will come back into the natural gas market. Low natural gas prices compared to coal should also encourage power plants to substitute coal for cheap gas. However, the substitution can be limited in the short term. Indeed, coal-fired power plants need to have access to gas supplies and hence need to be connected to a gas pipeline. Second, the power plants generator needs to be able to switch fuel or the power plant needs to have a gas-fired generator in order to switch to natural gas. Finally, coal shipments to power plants are usually made through long term contracts and so this gives little flexibility for power plants to switch fuel. In summary, it is probably too soon to punt for a sustained rise in natural gas in the U.S, as a detailed look at the excessive inventory picture will show this condition may persist for a while. Nonetheless, we believe market balance will return by mid-year.

JANUARY 26,2012

ENERGY REVIEW

The Diapason Capital Markets Report

EIA Weekly Report: Natural Gas

US Natural Gas Net Injections
150 100

The last EIA report showed that US natural gas inventories fell by 192 billion cubic feet (bcf) w/w but remained extremely high at 3098 bcf (+21.9 percent y/y), 3.78 standard deviations above the 2004-2008 average (compared to 4.27 the week before). Storage utilisation fell to 70.6 percent, significantly higher compared to the 5-year average of 56.4 percent. Storage capacity concerns are arising. Warmer than normal temperatures are expected and are likely to keep US natural gas demand weak.

50 0

B nc b fe t illio u ic e

-50 -100 -150 -200 -250 -300 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51

2004-2008 Average 2009 2010 2011 2012 Sources: Diapason, EIA

US Working Natural Gas Storage Utilisation

100%

US Working Gas Storage Utilisation 2004-2008 Average

90%

2009 2010

80%

6-10 day Temperature Outlook (Red: above normal/Blue: below normal)

70%

60%

50%

40%

30%

Sources: Diapason, EIA

20% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51

US Natural Gas Inventories Standard Deviations from 2004-2008 Average

7.0 6.0

STDEV STDEV STDEV STDEV

2009 2010 2011 2012

(lhs) (lhs) (lhs) (lhs)

5.0

4.0

3.0

2.0

1.0

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39

Sources: Diapsons, EIA

41 43 45 47 49 51

Source: NOAA
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JANUARY 26,2012

ENERGY REVIEW

The Diapason Capital Markets Report

Thinking in Essentials - Energy Markets Dynamics

Natural Gas Market Dynamics
Demand:
The EPA recently finalised the new rule on emissions that is likely boost

US Natural Gas Demand and Supply (Billion cubic feet per day) Demand Residential Sector Commercial Sector Industrial Sector Electric Power Sector Other US Natural Gas Consumption y/y Change Supply Total Dry Production LNG Gross Imports Pipeline Gross Imports Gross Exports Net Imports Net Withdrawals from Inventory Supplemental Gaseous Fuels Supply US Natural Gas Supply y/y Change 2010 13.12 8.5 17.86 20.24 5.42 65.14 3.8% 2010 58.44 1.18 9.07 3.11 7.13 -0.02 0.18 65.73 4.3% 2011 13.19 8.78 18.48 20.73 5.74 66.92 2.7% 2011 62.97 0.93 8.45 4.26 5.12 -1.00 0.17 67.26 2.3% -0.34 2012 13.49 8.84 18.64 21.4 5.86 68.23 2.0% 2013 13.45 8.85 18.89 22.03 5.92 69.14 1.3%

natural gas demand from the power sector. However, this will only have an impact by mid-2012 or 2013.
Current warmer than normal temperature in the US is reducing demand

for natural gas.

In 2012, the power sector is likely be a more important contributor to US

natural gas demand growth, thanks to low gas prices compared to coal and new regulations on emissions.

Supply:
Chesapeake announced an important cut of dry gas drilling activity. Pro-

duction will be immediately cut by 0.5 Bcf/d or 8 percent of its production. Production could be cut further by another 0.5 Bcf/d, if necessary.
Supply growth is expected to slowdown in 2012 (+1.3 percent y/y com-

pared to +2.3 percent y/y in 2011) because or reduced drilling plans for natural gas. Gas supply growth is hence expected to be lower than gas demand growth, leading to a slight deficit.
The EIA decreased unproved technically recoverable resource from the

2012 2013 63.51 64.68 0.69 0.69 8.1 8.12 4.46 4.48 4.33 4.32 0.34 -0.12 0.18 0.18 68.36 69.06 1.6% 1.0% -0.13 0.08

Marcellus shale from 410 trillion cubic feet to 141 trillion cubic feet (-66 percent!).

Balancing Item (Consumption - Supply) -0.59

* Foreast

Source: Diapason

Inventories:
US natural gas inventories are declining but remained higher than previ-

ous years for the season.

Colder than normal temperatures are therefore required to reduce inven-

tories back to normal level.

For important Disclaimers and Disclosures, please refer to the last two pages of this publication

The Diapason Capital Markets Report Contact Information

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The Diapason Capital Markets Report is published and edited by Robert Balan, Senior Market Strategist
Robert Balan has more than 3 decades of experience in the financial markets. Education in mining engineering and computer science led to a commodity analysis career during the commodity boom of the early 1970s. Robert made a switch to global macro focus in the early 1980 when the commodity bull market waned, with specialization in foreign exchange. Robert wrote a very high profile daily FX analysis while Geneva-based in the mid-1980s (the first FX commentary with a real global readership, "most accessed" in the Reuters and Telerate networks from 1988 to 1994). He worked for Swiss Bank Corp and Union Bank of Switzerland (precursors of todays new UBS) as head of technical research and proprietary trader in various major finance centers (London, New York, and Toronto) from late 1980s to mid-1990s. A stint at Bank of America as head of global technical research (London, New York) followed in late 1990s to early 2000s. He returned to Switzerland in 2004 as head of technical research and strategy, and FX market analyst for Swiss Life Asset Management in Zurich. He joined Diapason Commodities Management in 2008 as senior market strategist utilizing macro-economic drivers and structural/technical data in modeling asset price and sector movements. Robert wrote a book on the Elliott Wave Principle in 1988, hailed by the London Society of Technical Analysts as best book ever written on the subject. Robert is a member of the National Association for Business Economics (NABE), USA.

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The Diapason Capital Markets Report

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Last update on 9 February 2011

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10