(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON (Reuters) - Steelmaker Nucor will help protect expansion of U.S. iron and steel making capacity against an expected future rise in U.S. natural gas prices by taking a 50 percent working interest in onshore gas wells to be drilled and operated by Encana.
The agreement builds on an earlier, smaller agreement between the two companies struck in 2010. But the increased number of wells covered offers Nucor much more protection against future variations in the price of natural gas, which is one of the biggest input costs for its iron and steel operations.
"The drilling of gas wells resulting from the two agreements is expected to provide enough natural gas to equal Nucor's usage at all of our steel mills in the United States" plus a new direct reduce iron facility under construction in Louisiana as well as another plant the company is thinking of building in the state, according to a company statement. Alternatively it covers enough gas to fuel three direct reduced iron plants.
Nucor said it expects to invest about $542 million over the next three fiscal years and approximately $3.64 billion over the estimated 13 to 22 year term of the agreement.
"Either party may suspend drilling operations if the average price of natural gas falls below a pre-determined threshold for thirty consecutive business days," it said.
FUTURE GAS PRICES
The agreement is a clever solution to the strategic problem currently confronting both gas producers and consumers in North America, struck between America's most innovative steelmaker and one its most sophisticated oil and gas producers.
Surging domestic gas production from shale and low natural gas prices are expected to provide a long-term competitive advantage to energy-intensive industries in the United States.
Low gas prices have already prompted a wave of reactivations of previously idled plants producing fertilizer, cement, glass, steel and petrochemicals.
Many energy-intensive industries are now planning expansions for the first time in more than a decade.
No one expects prices to remains this low forever. Most gas-users expect prices to rise moderately in the next few years as demand increases and gas producers cut output to curb the problem of oversupply.
But so long as price rises remain moderate, and U.S. gas remains cheap compared with oil, as well as oil-indexed prices in other regions, it will remain a source of competitive advantage.
The problem is that no one knows how high gas prices might rise in the medium term. By taking a working interest in new gas wells equivalent to use entire U.S. gas use, Nucor has essentially hedged its forward consumption.
Hedging by taking a working interest in new gas developments, rather than via futures or swaps, is likely more efficient. Liquidity in the derivative markets is generally limited beyond 2-3 years ahead, which is not long enough for a big capital project, and the company will avoid problematic margin payments.
Investing in wells, rather than putting on a financial hedge, has the benefit that it will directly help ensure future supplies, at moderate cost. The deal will help ensure the golden age of gas remains a reality in the medium term.
Nucor is cutting out the middle-man by managing price risk directly. Normally this service would be provided by banks or trading houses.
The agreement also solves the problem confronting gas producers. The "golden age of gas" is proving anything but golden for companies specializing in gas production in North America. Falling prices have squeezed cashflows brutally.
Gas producers are under fierce pressure to conserve cash by cutting investment expenditures in the near term.
At the same time, most want to protect their investment in highly prospective gas acreage in anticipation of a future improvement in prices as the current gas glut is worked off and the market rebalances.
Encana has trumpeted its strategy of enhancing its financial strength and flexibility through divestitures and entering into joint ventures to achieve immediate value recognition, maintain capital and operating efficiencies and de-risk capital programmes by sharing the risk with others.
"Joint venture partners are expected to partially fund development of select plays," the company boasted in its most recent corporation presentation ("Maintaining financial strength while transitioning to a more diversified portfolio" November 2012).
"(We) will only spend beyond cash flow once additional proceeds are secured through divestitures or JVs" the company promised in a discussion of its capital programme. And it promised to "accelerate third party funding."
Which is precisely what the big new deal with Nucor will achieve.
The big problem with the U.S. shale revolution has been how to ensure a sustainable division of value between gas producers and consumers that will support the steady, long-term expansion of both supply and demand, rather than an unsustainable boom and bust cycle.
The problem is especially acute because many projects, such as building LNG export terminals, building new steel mills and petrochemical plants, or converting large parts of the transportation system to use natural gas, involve big upfront capital investments that could leave investors hostage to a future rise in gas prices.
At the same time, gas supply will only continue to expand if exploration and production companies can be sure of future demand.
Deals such as the one between Nucor and Encana minimize risk for both sides and are set to become much more common in future.
(Editing by Richard Mably)