(John Kemp is a Reuters market analyst. The views expressed are
By John Kemp
LONDON Nov 6 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
"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 fertiliser, 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
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 proejct, and the company will avoid problematic
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
The agreement also solves the problem confronting gas
producers. The "golden age of gas" is proving anything but
golden for companies specialising 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
"(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
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
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
Deals such as the one between Nucor and Encana minimise risk
for both sides and are set to become much more common in future.
(editing Richard Mably)