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Can the surprise jump in natural gas rigs last?

Natural gas rig counts have been flat or rising for the past four weeks, but they rose sharply last week

Baker Hughes, an oilfield services company, reported that rigs targeting natural gas rose from 369 to 388 for the week ending August 2, a large increase over the period of a week. From May 17 through July 5, the rig count had been range-bound between 349 and 354. However, rig counts have been flat or rising for the past four weeks, up 33 in total since July 5. Prior to that, rigs had largely been trending downward or flat. But the trend over the last four weeks may signal that natural gas rig counts have bottomed out. Recently, though, natural gas prices have taken a sharp downturn, falling from ~$3.80 per MMBtu (millions of British thermal units) to ~$3.35 per MMBtu over two weeks. Given the large price decrease, companies may reverse course and slow natural gas drilling activity.

2013.08.02 - Nat Gas Rig CountsEnlarge Graph

Despite rising natural gas prices earlier this year, natural gas rigs decreased

The rig count had largely been decreasing throughout early 2013, even as prices had experienced a strong rally from $3.15 per MMBtu in mid-February to ~$4.40 per MMBtu in mid-April. Natural gas currently trades around $3.60 per MMBtu. The drop in rig count from February through April could have signaled that despite the strong rally, natural gas prices of over ~$4.00 per MMBtu still aren’t high enough to incentivize producers to shift significantly more capital towards natural gas and that there’s no compelling reason to increase natural gas rig counts. Also, in the last two months, natural gas rigs drilling have been relatively flat, staying within a narrow range near 350. This could perhaps signal a bottom, the bare minimum of natural gas drilling that the upstream sector is willing to fund in the present environment.

Natural gas rigs have fallen over the past few years also due to low prices

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 the natural gas price graph below).

2013.08.02 - Nat Gas 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 Range Resources (RRC).

The number of rigs drilling can reflect producer sentiment

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 (positive) 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.

Despite falling rig counts (implying reduced drilling), natural gas supply has remained flat

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

2013.08.02 - US Nat Gas ProductionEnlarge Graph

There are a few major likely reasons why natural gas production hasn’t yet followed the drop 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 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 the by-product being associated natural gas production.
  3. Producers have become more efficient at producing more gas with fewer rigs due to advancing technology and deeper knowledge about the areas in which they’re drilling.

That’s not to say that supply cuts won’t happen at all. Note that in the above graph, U.S. natural gas production goes only through May 2013, as that’s the last period that the DOE (U.S. Department of Energy) has reported so far. We have yet to see what the DOE will report for June and July. Plus, 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 have shifted their budgets towards drilling oil rather than gas.

But so far, the rig reductions haven’t put a significant dent in natural gas supply. So 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). Plus, 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.

Questionable outlook

Natural gas rigs increased last week as well as over the past several weeks. If natural gas rigs drilling increase further, they may signal that companies are more optimistic about the natural gas production environment. However, with the sharp price decrease in natural gas over the past two weeks, companies may reverse course and slow natural gas drilling.