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Nat gas rigs dropped to new lows despite better price environment

2013.04.01 - Baker Hughes Natural Gas Rigs STEnlarge Graph

  • Natural gas rigs decreased last week from 418 to 389 in what was the largest single weekly decrease since February 2012.
  • The large rig count was somewhat surprising given the recent rise in natural gas prices to $4.00/MMBtu from $3.15/MMBtu in mid-February.
  • Rig counts are down 11% since the beginning of the year.
  • Natural gas rigs have generally been declining or flat since 3Q11.
  • 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 decreased from 418 to 389 for the week ending March 28. This was the largest weekly decrease in natural gas rigs drilling since February 2012, which was somewhat surprising as natural gas has recently had a strong rally. As recently as mid-February, natural gas was trading at $3.15/MMBtu, but since then prices rose to over $4.00/MMBtu.

Last week saw a significant drop off in natural gas rigs, continuing a trend that began in October 2011 as rigs specifically targeting natural gas saw declines given sustained low natural gas prices (see natural gas price graph below).

2013.04.01 - Nat Gas Prices LtEnlarge 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 week’s increase in rigs may be a signal that producers are feeling bullish about the current price environment.

As aforementioned, rig counts had largely been in decline since late 2011. With this decline in rigs throughout 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 thus far, with prices rebounding somewhat since 2Q12 lows, but mostly from demand drivers rather than supply cutbacks.

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 December 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 January and February. 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 an decrease in rig counts, which can be construed two ways (1) that producers are feeling less positive about natural gas drilling given the rise in prices and (2) that a decrease in rigs could decrease natural gas supply which would create positive price pressure.