Natural gas rigs rose yet again – possible reversal of downward trend?

Market Realist

Natural gas rig counts rose for second week in a row

Baker Hughes, an oilfield services company, reported that rigs targeting natural gas increased last week to 369 (up from 362) for the week ending July 19. From May 17 through July 5, the rig count had been range-bound between 349 to 354. However, rig counts rose for the past two weeks, up 7 for each of the past two weeks. Rigs had largely been trending downward or flat, however, if rig counts continue to rise this might signal a reversal to the trend.

(Read more: Why natural gas continues to lose market share to coal)

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/MMBtu in mid-February to ~$4.40/MMBtu in mid-April. Natural gas currently trades around $3.60/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/MMBtu still are not high enough to incentivize producers to shift significantly more capital towards natural gas and that there is no compelling reason to increase nat 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.

(Read more: Spread between WTI crude oil and Brent oil has closed in significantly since YE2012)

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 natural gas price graph below).

(Read more: WTI-Brent continues to close, trading at tightest levels since January 2011)

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 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.

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

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. 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 relative to rig count declines.

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 April 2013, as that is the last period that the DOE has reported thus far. One has yet to see what the DOE will report for May and June. 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 have shifted their budgets towards drilling oil rather than gas.

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.

Natural gas rigs increased slightly last week. If natural gas rigs drilling increases further, it may signal that companies are more optimistic about the natural gas price environment. However the past two weeks’ data points are not enough to draw a real trend. Note also that natural gas rigs had remained roughly flat for the past two months, despite some price volatility. This may also signal a bottom, or reflect the bare minimum of capex that upstream companies are willing to spend on drilling gas at the moment.

More From Market Realist

View Comments (4)