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Fall off in natural gas rigs could be sign of producers’ bearish sentiment

2013.02.28 - US Nat Gas RigsEnlarge Graph

  • Natural gas rigs fell last week from 428 to 420 and a continuation of that trend could signal further bearish sentiment from producers and could eventually result in decreased supply.
  • The number of natural gas rigs drilling has been falling or flat since October 2011, however, natural gas production has been growing/flat over the same period.
  • A focus on the most productive wells, an increase in efficiency, and gas produced as a result of oil-targeted drilling are all factors that have contributed to flush natural gas supply despite a cutback in rigs.

Baker Hughes, an oilfield services company, reported that rigs targeting natural gas dropped from 428 to 420 for the week ending March 1. The above chart shows natural gas rigs drilling since January 2011.

As seen in the chart above, rigs specifically targeting natural gas had largely fallen off since October 2011 given sustained low natural gas prices (see natural gas price graph below). However, for the past two quarters, the number of natural gas rigs drilling has been roughly flat.

2013.02.28 - Nat Gas PricesEnlarge Graph

Natural gas supply and prices are major drivers of valuation for natural gas producers such as Chesapeake Energy (CHK), Comstock Resources (CRK), Southwestern Energy (SWN), and EXCO Resources (XCO).

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 decreased by 8 and a continued decrease in rigs could signal bearish sentiment by producers, but it is difficult to extrapolate a trend only from this week’s data point. The number of natural gas rigs drilling has been range-bound between 415 and 440 since October 2012.

With this decline in rigs through the last part of 2011 and most of 2012, 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 through 2012, 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 two years and one can see that supply has not fallen off significantly, but rather has grown or remained flat.

2013.03.04 - Nat Gas ProductionEnlarge Graph

There are a few major likely reasons why natural gas production has not yet followed the drop off in rig counts.

  1. The rigs targeting gas right now are likely targeting the most productive and economic wells, and the rigs that were put out of work were targeting the more marginal wells. This has resulted in a large cut in rigs, without a proportionate cut in supply.
  2. Rigs that are classified as targeting oil are not included in the natural gas rig count, and oil wells produce both oil and natural gas (often called “associated gas” when it comes from an oil well). Oil prices have remained relatively robust, and the pace of oil drilling has remained frenzied, with the by-product being associated natural gas production.
  3. Producers have become more efficient at producing more gas with less rigs due to advancing technology and deeper knowledge about the areas in which they are drilling.

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 past week saw a reduction in rig counts, and if this trend continues over the following weeks it could signal further bearish sentiment from producers and could possibly result in a supply reduction which would be positive for prices. However, over the prior few months the number of natural gas rigs drilling has been roughly flattish and this week’s data point in itself is not enough to represent a real trend.