Natural gas rigs fall to new lows, signaling continued shift away from gas

2013.06.24 - Nat gas rig countEnlarge GraphNatural gas rigs dipped slightly last week to the lowest natural gas rig count in over ten years

Baker Hughes, an oilfield services company, reported that rigs targeting natural gas dipped last week to 349 (down from 353) for the week ending June 21. The rig count has largely been decreasing week over week during 2013, even as prices experienced a strong rally from $3.15/MMBtu (thousand British thermal units) in mid-February to ~$4.40/MMBtu in mid-April. Natural gas currently trades around $3.75/MMBtu. The drop in rig count from February through April could signal that despite the strong rally, natural gas prices of over ~$4.00/MMBtu still aren’t high enough to motivate producers to shift significantly more capital towards natural gas.

We’ve been seeing a general decline in natural gas rigs

Natural gas rigs have dropped off steeply since mid-March, when rigs numbered 431. Also, natural gas rigs are down significantly from year end 2012, when they numbered 439. From a longer-term perspective, natural gas rigs have been largely falling or flat since October 2011 in response to sustained low natural gas prices (see natural gas price graph below).

2013.06.24 - Nat Gas LTEnlarge Graph

Why are rig counts important?

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 Range Resources (RRC).

To provide some context, the number of rigs drilling for natural gas can indicate 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 indicate 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.

Last week’s decrease as well as the longer-term decreases in rig counts may be a signal that producers are starting to feel even more negative about the natural gas environment, or at least that capex (capital expenditure) is better spent on liquids-rich assets.

A focus on the most productive wells, an increase in efficiency, and gas produced as a result of oil-targeted drilling have all contributed to flush natural gas supply despite a dramatic cutback in rigs

As we’ve seen, rig counts have largely declined since late 2011. With this decline in rigs throughout most of 2012, you’d expect a drastic cutback in natural gas production and therefore a bump in prices and natural gas producer valuations. Despite this expectation, supply has remained mostly flat so far, with prices rebounding somewhat since 2Q12 lows—but mostly as a result of demand drivers rather than supply cutbacks. The following chart shows natural gas production in the U.S. over the past 12 months. You can see that supply hasn’t fallen off significantly relative to rig count declines.

2013.06.11 - US 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. First, 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. Second, rigs that are classified as targeting oil aren’t 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 associated natural gas production as the by-product. Third, producers have become more efficient at producing more gas with fewer rigs due to advancing technology and deepening knowledge of the areas they’re drilling in.

That isn’t to say that we won’t experience any supply cuts at all. Note that in the above graph, U.S. natural gas production runs only through March 2013, as that’s the last period that the Department of Energy (DOE) has reported thus far. We have yet to see what the DOE will report for April and May. Additionally, companies plan their expenditures year by year, and it’s likely that given the continued low price of natural gas and continued support in the price of oil, companies will further shift capital away from natural gas and towards oil in their 2013 drilling budgets.

Natural gas rig declines signal that producers are negative about the current price and operating environment

However, so 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 U.S. Natural Gas Fund (UNG), an ETF (exchange-traded fund) designed to track Henry Hub natural gas prices, the major domestic benchmark for the commodity.

Natural gas rigs declined last week and have declined over the past few months, even during a period of steeply rising gas prices, signaling that producers prefer not to drill natural gas given the current price and operating environment. Ultimately, this could be positive for natural gas if supply cutbacks result in higher prices, though the data in the short-term point to unfavorable economics for gas drilling.