As seen in the chart above, rigs specifically targeting natural gas have largely fallen off since October 2011 given sustained low natural gas prices (see natural gas price graph below).
To provide some context, the number of rigs drilling for natural gas can be indicative of how companies feel about the economics of drilling for natural gas. More natural gas rigs drilling generally means companies feel bullish on the natural gas environment. Additionally, rigs drilling can also be indicative of future supply as more rigs drilling implies more production. Therefore, market participants monitor rig counts to get a sense of oil and gas producers’ sentiment and as a rough indicator of future expected supply.
This past week, natural gas rigs increased by 7 which was an unusual data point given the longer term trend of decreasing natural gas rigs. In the 73 weeks since October 2011, only 10 weeks showed natural gas rigs increasing by 7 or more. Note that this week’s movement upward in natural gas rigs is only one data point, and is too isolated to be called a trend. However, if the number of natural gas rigs drilling continues to increase, it would be a reversal to the clearly negative trend in natural gas rigs since 3Q11 and it could be interpreted in several different contexts. On one hand, more rigs drilling could mean that producers are beginning to feel more confident about the natural gas environment, either because they expect gas prices to rise or because they have been able to drill their gas assets more economically resulting in profitable wells even at today’s depressed prices. On the other hand, if drilling is increasing for other reasons, such as the necessity of drilling on leases that are due to expire, this puts more natural gas supply on the market which is potentially unprofitable. In either case, more supply has the effect of depressing natural gas prices, which consequently depresses the valuation of natural gas producers.
Last week rig counts increased, however, as aforementioned, rig counts have been steeply decreasing since 3Q11. With this decline in rigs, one would expect a drastic cutback in natural gas production, and therefore a bump in prices and natural gas producer valuations. Despite this, supply has remained flattish thus far, with prices rebounding somewhat since 2Q12 lows, but mostly from demand drivers rather than supply cutbacks. The below chart shows natural gas production in the US over the past twelve months and one can see that supply has not fallen off significantly.
There are a few major likely reasons why natural gas production has not yet followed the drop off in rig counts.
That is not to say that supply cuts will not be experienced at all. Note that in the above graph US natural gas production goes only through November 2012, as that is the last period that the DOE has reported thus far. One has yet to see what the DOE will report for December and January. Additionally, companies plan their expenditures year by year, and it is likely that given the continued low price of natural gas and continued support in the price of oil, that companies will further shift capital away from natural gas and towards oil in their 2013 drilling budgets.
However, thus far the rig reductions have not put a significant dent in natural gas supply. Therefore, natural gas prices have remained relatively low which has muted the margins and valuation of domestic natural gas weighted producers such as Chesapeake Energy (CHK), Comstock Resources (CRK), Southwestern Energy (SWN), and EXCO Resources (XCO). Additionally, natural gas prices affect the US Natural Gas Fund (UNG), an ETF designed to track Henry Hub natural gas prices, the major domestic benchmark for the commodity. This week’s short-term negative catalyst of increased rigs drilling could further exacerbate the current problem of excess natural gas supply if the trend continues.
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