Differences between Capacity and Production

Value and myself have a significant disagreement. I argue that production is down and this is important indicator of the declining ability of the natgas industry to produce. Value argues that because of shut-ins this is very misleading. Let's start by looking at some charts to try to understand the nature of the industry and the data we receive.

The graphic below is designed to show the nature of the stock of wells and the 'flow' or changes in the stock of wells.
There are three types of wells: Prospective wells that have not been drilled, drilled wells and producing wells. Every wells starts out as a prospective well (for example a drilling permit is obtained). Then it is drilled. Finally, it is completed and hooked up to a sales line and produced. Thus, some wells get drilled and are in the blue area in the graph below, but are not yet producing (in the green area). Each period, some prospective wells are drilled and moved from the white area to the blue area. Likewise some drilled wells (blue) start producing and are moved to the green area. Finally each period some wells have such low production that they are abandoned and no longer in the green area. The point of this graphic is to highlight the STOCK of wells and the FLOW of wells.

This alone is complicated and some people have difficulty in dealing with the difference between the stock of wells and the flow (or number of wells drilled in a period). But that is not all! In addition, the natgas industry has the flow of actual natural gas from these wells. The graphic below shows the flow of natgas from the green areas.



We now have the total production starting to fall from very high levels. But we need to examine the situation at a greater level of detail to understand what is happening. Below is a blowup of the production process.


Note how each well (green area) produces natgas and adds to the turquoise area on the right. The size of the green areas is an indication of the size of the well's productive capacity. But wells don't have the same production in every period. Each period a well is produced lowers the size amount of the resource left, which means the production level must fall over time. The graphic below shows this happening. Note that the lines from the fields to the total production can be controlled. In other words, a firm can stop production or curtail production at a field to a lower level. While this may have costs and actually decrease the total amount of production over time, the voluntary cutback of production does happen.



Notice the 'white' boxes in the producing fields. This represents less productive capacity in each well. (I could have also made each green area slightly smaller, but the boxes make the point). Likewise every period new wells (the purple colored areas) are added. The question then becomes is the loss of the green areas greater or less than the new purple areas? I am arguing because the shale wells are very high depletion wells, the white areas are 'large'. Thus, if the number of purple areas is small, the total area or total productive capacity will fall. Value as I understand it, is arguing that the turquoise area is lower because of voluntary cuts in production, not less the fact that the total green and purple area on the left is smaller.

But now look at the charts in the prior post and see the HUGE drop in drilling horizontal wells. This drop means the number of wells moving from the white in the first graphics to the blue is falling. Thus, the number of wells moving from the blue to the green must also fall. Clearly it takes time for a well to move through the process, but as the number of wells drilled continues to fall, the RATE at which the wells are moving into the green area has to fall. Thus in the lower graphics the size of the new purple areas (new wells on production) has to fall. But the depletion (white areas) of the are HUGE. Some estimates of new wells are 50+% in the first year. Thus, the total depletion (white area in the lower graphics) is large, which requires large amounts of new wells (purple) to keep production EVEN.

So who is right? The problem is we don't have the data to determine exactly what is happening. The data on the 'potential' or maximum production level of the producing wells is unknown. We do have some evidence that production is being held back. But the large decreases in production are significantly higher than the reported voluntary cutbacks. (But Value has the opposite opinion.)

Without a doubt, if natgas prices rise back to $10, then several things will happen:
More drilling will occur.
Some wells that have production withheld will increase production
Some wells that are drilled but not producing (blue area in 1st graphic) will be brought online.
As a result, I do see limited upside to the natgas price. Too high a price will bring large production increases. But too low a price will cause the net capacity of the industry to fall.