Why the number of natural gas rigs drilling increased slightly

Ingrid Pan, CFA

Natural gas rig counts increased slightly last week

Baker Hughes, an oilfield services company, reported that rigs targeting natural gas edged up slightly last week to 388 for the week ending August 16. From May 17 through July 5, the rig count had been range-bound between 349 and 354. However, natural gas rig counts have largely been rising since then to current levels of nearly 390.

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(Read more: Why ethane stopped trading like crude and started trading like nat gas (part II))

Despite rising natural gas prices earlier this year, natural gas rigs had 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 weren’t high enough to incentivize producers to shift significantly more capital towards natural gas and there was no compelling reason to increase natural gas rig counts.

But natural gas rig counts have risen ~10% over the past two months despite relatively weak prices of between $3.30 per MMBtu and $3.80 per MMBtu during that period. This could perhaps signal that companies expect natural gas demand to pick up or have more capital to spend on natural gas drilling, or possibly that natural gas rigs have become cheaper to contract out and so companies are using more right now.

Natural gas rigs have fallen over the past few years 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).

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(Read more: Why ethane stopped trading like crude and started trading like nat gas (part III))

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 show 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. Plus, rigs drilling can also indicate future supply, as more rigs drilling imply more production. So 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 over the long term (implying reduced drilling), natural gas supply has remained flat

As we’ve seen, rig counts had largely been in decline 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 flattish so far, with prices rebounding somewhat since 2Q12 lows—but mostly from demand drivers rather than supply cutbacks.

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(Read more: An Introduction to Oil and Gas Hedges: Collars)

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 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 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 they’re drilling.

That isn’t to say that supply cuts won’t occur 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 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. This 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 exchange-traded fund designed to track Henry Hub natural gas prices, the major domestic benchmark for the commodity.

Positive outlook ahead?

Natural gas rigs increased slightly last week, and are up ~10% over the past two months. If natural gas rigs drilling increases further, it may signal that companies are willing to spend more money on developing natural gas properties and are more optimistic about the natural gas price environment. Note also that natural gas rigs had remained roughly flat for most of May and June, despite some price volatility. This may also signal a bottom—or reflect the bare minimum of capex (capital expenditure) that upstream companies are willing to spend on drilling gas at the moment.

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