The Natural Gas Sector, Shale Gas & Exxon's $31 Billion Takeover of XTO Energy

Yesterday's big news in the commodities world was Exxon's $31 billion takeover of XTO Energy.

The acquisition is a big endorsement by the world's largest energy company. The majority of XTO's assets are U.S. shale gas properties. With the buyout, Exxon is essentially saying they see a big future in shale.

It's certainly true that shale gas is one of the biggest "new things" to come along in the energy space for some time.

However, there are a few factors that should give investors pause when they consider natural gas.

One of the chief considerations being the oil-to-gas price ratio. And its unusual effects on drilling costs.

Let's look at this issue a little closer. The crux is this: the ratio of oil to gas prices is near record territory. A barrel of oil currently trades at nearly 14 times the price of an mcf of natural gas. Well above the historical average of 7.

What does this mean for the gas sector? Consider the dynamics of drilling gas wells. Low gas prices are not necessarily a problem for gas producing companies. Several years ago, producers made money pumping gas at $2 per mcf. The trick then was drilling and services costs were much lower. And with lower input costs, producers could still turn a profit at a low gas price.

Lately we've once again reverted to relatively low gas prices. Shale gas has in some ways become its own enemy by flooding North America with new supply, at a time when demand has stagnated.

There has been much speculation that the gas sector is unsustainable at current prices. This misses the point: the current price would be fine, as long as costs for input services like drilling go down.

Here's where the oil-to-gas ratio becomes an issue. With oil prices relatively elevated ($70 per barrel is a very decent price for the crude industry), oil producers have been very active drilling new wells. Over the last six weeks, nearly 200 new rigs have been called into service across North America.

Of course this oil-driven demand for rigs means that rig prices are remaining relatively high across the industry. Which also affects gas producers. The high oil price means that even with low gas prices we aren't seeing a drop off in rig demand. And no drop in rig prices that might help improve profitability in the gas sector, the way it did during previous price busts.

This is going to be a very challenging environment for gas producers. Until either oil prices fall, or gas drilling demand declines to the point where it starts to bring down rig prices in spite of elevated levels of oil drilling.

Here's to the soon-to-be late XTO,

By. Dave Forest of Notela Resources