In our Musings of December 6, 2011, we concluded an article about the future of the natural gas market with the observation that "with less opportunity to bolster cash flow from hedging and joint venture cash, a likely decline in gas drilling appears on the horizon." Increasingly, gas producers are cutting back their efforts directed towards drilling wells targeting dry gas resources and instead focusing on crude oil and natural gas liquids (NGLs) wells. These "liquids-rich" plays, unfortunately, contain a significant amount of associated natural gas that is helping sustain gas production growth even as the number of rigs targeting dry natural gas is falling. However, it is still possible that this shift in drilling focus will provide the catalyst for a decline in gas production, which would ultimately yield a corresponding rise in gas prices.
With the decline in the number of rigs drilling for dry natural gas, one has to question whether producers are finally coming to their senses about the weak economics of these drilling efforts. If they are, then the industry is on a track that will sustain higher gas prices as the volume of associated natural gas produced with crude oil or NGLs will eventually fall short of offsetting the decline in production from earlier, highly-prolific dry gas shale wells. When gas production growth flattens and eventually declines, as we suspect will happen but we aren't sure exactly when, it will be the increase in natural gas demand that will drive prices up. Eventually, if gas production falls sufficiently, prices will rise to levels that will make more dry gas drilling economic as has been the pattern that underlies the history of the oil and gas exploration business.
If we examine what has happened to the drilling industry over the past few years we can clearly see how the drilling focus has shifted from natural gas to liquids plays - crude oil and NGLs. That shift is demonstrated by the chart in Exhibit 1. The chart shows the number of active rigs drilling for natural gas versus those targeting oil since the start of 2005. For most of this period, natural gas was the favored target, but as gas prices continued to fall to very low levels and oil prices soared back to the $100 per barrel mark, oil and NGLs became the desired drilling target due to the superior economics of liquids. Rigs drilling for liquids surpassed the number of gas rigs beginning in the second half of April this year.
The pace of the switch toward oil-oriented drilling has accelerated since the start of September as seen in the chart in Exhibit 2. In the past eight weeks, the number of rigs drilling for oil has increased by 123, but the total drilling for gas has fallen by a 132. The result has been that the spread between the numbers of oil rigs versus gas rigs, which stood at 144 on October 28th, has increased to 399 as of December 22nd. The drilling shift has accelerated with the sharp fall in natural gas futures prices ($3.92 per thousand cubic feet as of October 28th to $3.11 on December 23rd) as traders' hopes for an early cold spell to sweep across the nation, or at least in the heavily populated regions, and boost gas demand has not materialized. With the lack of a boost in gas demand, gas volumes withdrawn from storage have not exceeded weekly withdrawals experienced last year or compared to the average weekly withdrawals of the past five years. Gas storage volumes remain enormous and with continued growth in gas production, not only have current natural gas prices fallen but prospects for higher future prices have evaporated. Along with those disappearing prices has gone the opportunity for producers to hedge future production at higher prices, which has helped to boost their cash flows during the past several years, a necessary ingredient to sustain the uneconomic gas drilling they have been engaged in.
The impact of this shift in drilling can also be seen by looking at the trend in the number of drilling rigs working in the six major shale basins in the United States. While the total number of drilling rigs working in these basins since the Land Rig Newsletter began
reporting them in early May 2010 has increased 31% from 461 to 602 at the start of December; there have been noticeable shifts in the number of rigs working in the various basins based on their orientation toward dry gas or liquids resources. Exhibit 3 shows the number of rigs working in these shale basins and how that number has changed over time.
If we consider the impact of the decline in natural gas prices versus the rise in crude oil prices and their respective impacts on drilling economics we can see how producers have made major adjustments to their drilling programs. From early 2010 to December 2011, the three predominantly dry gas basins have collectively experienced a 38% decline while the liquids-oriented basins have experienced a corresponding 181% drilling activity increase.
Our December 6th article on the future of the natural gas industry discussed the declining opportunities for producers to tap outside capital sources and how we anticipated this lack of money would
cause gas-oriented drilling to decline helping to eventually boost gas prices. The capital raised from hedges, stock and bond offerings and joint ventures has sustained the industry's acreage acquisition and drilling efforts in the face of low and declining gas prices. To begin to understand investor perceptions for the future of natural gas producing companies, one needs only to examine two index performance charts composed of share prices for 16 E&P companies who also happen to be leading the gas shale revolution. Exhibit 5 shows the price action for this index (EPX-NYSE) compared to the overall stock market as reflected by the performance of the S&P 500 Index over the past four years. The charts show how the gas producers have outperformed the overall market, even though they failed to generate a positive return for investors. The overall market fell by 15% during this time period. Notice also that only in late 2008 and early 2009 did the performance of both the EPX and the S&P 500 match each other. The remainder of the time the EPX index outperformed the market.
When we examine a shorter period – the last six months – the results are markedly different as the gas producers started by outperforming and then fell behind. The initial outperformance coincided with investor expectations that the economy was starting a more robust economic recovery that would boost gas demand at the same time the gas rig count was starting to flatten and then decline raising expectations that gas supply growth was soon about to slow or possibly even fall. As late summer turned into fall and doubts about the health of the economy arose and gas storage volumes grew because production was far outrunning demand growth, investors became less enamored by the flood of money being directed into drilling new dry gas wells. The result was investors began turning the back on the cash needs of the producers. They were only attracted by investment vehicles that emphasized cash income streams – master limited partners (MLPs) or royalty trusts. While one way to raise capital, it becomes more costly since producers need to set aside cash flow to repay investors for the slug of capital they have provided. In December, as signs that the underlying fundamentals of the natural gas business were not improving, gas futures prices collapsed and the overall stock market's outperformance compared to gas producers was dramatic with a ten percentage point spread sustained for the last half of the month. Some of the more recent underperformance may be attributed to investor tax-loss selling as we approach the end of calendar 2011.
The fall in gas prices has surprised most industry participants and investors who have viewed this more environmentally-friendly fossil fuel as possessing an attractive long-term outlook. That view has been driven by the gas shale revolution that has produced dramatically and progressively larger estimates of the volume of potential natural gas reserves in North America, highly prolific initial well production results and prospects that the country can not only sustain existing production flows for at least another 100 years or more but can become a significant exporter of liquefied natural gas (LNG). This latter focus has become a rallying cry for investors who see the LNG market as a way for producers with substantial volumes of natural gas to be able to sell it into a market that currently pays a substantially higher price than available domestically. The gas shale revolution has changed the search for natural gas from its prior focus on more-difficult-to-access conventional gas resources that were in a sustained downward trend in favor of highly-prolific and "economically-attractive" unconventional gas shale resources that are capable of being tapped by the application of advanced drilling and completion technologies.
In calling for a decline in gas production with this shift in drilling focus, we are counting on a continuation of the historical relationship between drilling and production. The government's Energy Information Administration's (EIA) Form 914 survey of natural gas production has shown nothing but steadily increasing volumes since it was started in January 2005. The most recent monthly data (September) showed one of the largest month-over-month increases in estimated gas production since the survey began, but it happened to coincide with a significantly large increase in the number of rigs drilling for gas. Since then, the number of gas drilling rigs has declined suggesting that the rise in gas production should also begin to flatten and subsequently decline. It should only be a matter of time, although time is a frustrating variable.
As natural gas futures prices have continued to decline hitting a recent low of $3.11 on December 23rd, prospects for increases in gas-oriented drilling appear slim. This is especially true given that spot gas prices have been as low as $2.80 in recent weeks. It would seem at some point, gas producers would stop drilling to enjoy the feeling of no longer beating their heads against a wall.
We know the relationship between gas prices and drilling rigs is a strong one as shown by the historical pattern since 1987 with the exceptions of 1999 and 2006-2007. The latter period was in the
early years of the gas shale revolution so producers were more focused on staking out land positions that required drilling wells to hold the acreage. In 1999, natural gas markets were just beginning to recover from the fallout from the collapse of commodity prices tied to the Asian currency crisis in 1998 but oil and gas companies' cash flows and desire to drill had yet to recover. Other than those two times, the relationship between gas prices and drilling activity has been consistent.
The consistent price/drilling activity relationship exhibited by natural gas also seems to hold for crude oil prices and oil drilling. It makes sense that these relationships exist because oil and gas prices are a key determinant in producer cash flows. Since producers usually reinvest most of their cash flows into new drilling, having more or less money available would seem to support changes in drilling activity.
Maybe more important than the relationship between oil and gas prices and drilling rigs seeking those resources is the relationship between natural gas prices and gas production. When we plot the gross withdrawals from all wells along with those just from dry gas wells against the price of natural gas, we find that there is a relationship. While some might argue that the changes don't appear significant (Exhibit 11), we would point out that the U.S. has been short of domestic supply so there was little incentive to limiting production unless it proved uneconomic due to the price. Declines in withdrawals may have also been a reflection of the depletion of existing well productive capacity that was not offset by new well production as fewer wells were drilled when gas prices fell. The point of this chart is that producers do respond to changes in natural gas prices even if only marginally. This would argue that the gas shale revolution and its demands for producers to continue to drill wells in order to hold the leases they have purchased has changed the natural response to low gas prices.
Another industry consideration about gas shale basins is that while the wells are initially highly prolific producers, their production decline is rapid. As a result, for gas production to be sustained at very high levels, producers need to climb on the treadmill of sustained active drilling. This phenomenon is best demonstrated by the following chart showing production in the Barnett gas shale basin when the industry stops drilling wells (static wells analysis). As shown by the chart (Exhibit 12), natural gas production from existing wells fell at a 44% annual decline rate when no new wells were added. For people who only focus on total production from a gas shale basin, they often ignore this natural phenomenon and attribute the rising production to the highly prolific nature of gas shale wells. Unfortunately, they are confusing trends in a gas shale basin with trends in individual wells. That can be a perilous mistake if producers are forced to quit drilling due to poor well economics.
The "bear" case for natural gas prices in 2012 is based on the belief that the liquids-rich wells currently being drilled will produce substantially more associated natural gas than assumed, and in some cases more than typical dry gas wells. The proponents of this view point to an estimate from the EIA that in the North Dakota Bakken oil shale basin due to a lack of pipeline capacity to take away the associated gas production, as much as 30% of it is being flared. It is clear that there is a substantial amount of associated natural gas being produced as demonstrated by the chart in Exhibit 13. Unfortunately, the chart, prepared by the North Dakota Department of Mineral Resources, ends in early 2010. The chart, however, shows the dramatic growth in the state's natural gas production since the Bakken formation oil shale play commenced in 2006 and that production continues to grow. For the last 12 months, the state's natural gas production has grown by 50%.
If we examine the latest monthly gas production data published on the state's web site, in October there was 15.73 billion cubic feet (Bcf) of gas produced, but only 9.67 Bcf sold. That represents a spread of 40%. If we assume that all this difference was flared, then producers burned 6.06 Bcf of gas in the month. Those figures are for October, a 30-day month, which suggests that the volume of natural gas burned was about 200 million cubic feet per day (MMcf/d). To put that volume into perspective, North Dakota's total daily production was about 525 MMcf/d. Total U.S. Lower 48 States gas production in September was 66.23 Bcf/d, as reported on Form 914. Since North Dakota gas production amounts to just less than 1% of this total, even if 40% of it is being flared, we doubt that this volume of potential future supply is putting significant downward pressure on the gas market and gas prices.
Despite natural gas prices remaining significantly depressed, we still believe the market could correct rapidly once it becomes evident that producers are beginning to reign in their gas drilling efforts. The drying up of funding sources and the significant underperformance of gas producer stock prices will lead to a different business environment. Either producers will begin living within their cash flows or some of them will be forced to stop drilling due to a lack of cash and available credit. Some producers may be forced to seek partners – a not uncommon phenomenon for this industry. Historically, merger and acquisition activity pickups up shortly after industry fundamentals have changed for the better. Stay tuned as the natural gas industry could be entering a whole new world as some bloodied producers decide to raise the white flag.
G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.
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