Musings: Falling Prices to Restrict Natural Gas Drilling Activity?
Natural gas futures prices recently slipped below the $4 per thousand cubic feet (Mcf) level. The drop was largely due to the unexpected gas storage injection reported last week. With expectations that gas storage volumes are likely to continue to build during the seasonally mild weather spring season, the fundamental outlook for natural gas has become extremely negative. At the same time, Wall Street firms are reducing their forecasts for natural gas prices this year. Tudor, Pickering, Holt & Co. lowered its average price for 2010 from $7.50 to $6.20/Mcf. Bernstein Research dropped its price to $7 from $9/Mcf. While many
Exhibit 1. Gas Prices Slumping After Winter Demand
Source: EIA, PPHB
bullish analysts and investors are disappointed by the weakness in natural gas prices, they realize prices could have fallen much lower had the nation not experienced weeks of super cold weather this winter. As gas storage volumes were about 4 trillion cubic feet (Tcf) at the start of the winter, they will end the withdrawal season at about 1.7 Tcf. Without the cold winter it is likely that natural gas prices would be substantially lower -- possibly a price well below $3/Mcf.
At the root of the gas price problem is a lack of significant natural gas demand growth coupled with a very modest decline in gas production due to the drop in drilling during the first half of 2009. Most analysts have attributed the lack of a meaningful fall off in gas production to the increase in drilling in gas shale formations. To test that thesis, we used a spreadsheet prepared by Baker Hughes (BHI-NYSE) that segregates the company's weekly rig count data from the start of 2008 through mid-March by major drilling basins and whether the rigs are drilling for oil or gas.
Exhibit 2. Gas Shale Drilling Outperforming All Gas Drilling
Source: Baker Hughes, PPHB
In this case, we plotted the number of gas-oriented drilling rigs working in East Texas, the Ft. Worth basin and Appalachia representing the Haynesville, Barnett and Marcellus gas shale formations against the total number of rigs drilling for natural gas in the country. We indexed the data to 100 at the start of 2008. As can be seen in the nearby chart, the gas shale rigs lagged the overall gas drilling count throughout most of 2008. However, as we entered 2009, gas shale drilling activity began to outperform the total gas-oriented rig count. What we know about gas shale drilling is that the initial production from these wells is extremely high, albeit for a relatively short time period. Therefore, as gas shale drilling began to dominate all gas-oriented drilling, gas production declines anticipated by the absolute decline in gas-oriented drilling were largely offset. Additionally, one should assume that producers drilling non-shale wells were "high-grading" their prospects, helping to ensure higher initial production from this smaller universe of conventional gas wells. Combined, there was a much smaller production response to the sharp fall in gas drilling activity than anticipated.
The depressing near-term outlook for natural gas markets was reinforced by Dr. Jonathan Lewis of Halliburton (HAL-NYSE) who spoke at the RMI Oilfield Breakfast. In response to a question from the audience about the impact of gas shale development on Halliburton's business, he stated that the company's fracturing horsepower was operating at the highest level ever. He also said that the backlog of drilled but uncompleted gas wells is growing due to the inability of the oilfield service industry to meet the demand for completion equipment. Dr. Lewis described the phenomenon of a large backlog of these wells as another form of natural gas storage since wells can be completed in the future when demand for the gas is present.
Dr. Lewis's observation about a growing backlog of drilled but uncompleted gas shale wells is in contrast to observations by some Wall Street analysts who believed this phenomenon was over. As oilfield activity fell during the first half of 2009, oilfield service companies reduced their list prices by offering increasingly higher discounts to gain work. Discounts were raised to levels at which certain company managements concluded that the hydraulic fracturing work was unprofitable and elected to park their equipment rather than work at cheap prices. That capacity reduction enabled the remaining companies to begin boosting prices by reducing discounts.
It is our understanding that hydraulic fracturing discounts have been steadily shrinking during the first quarter of 2010. At the same time, the upturn in gas shale well drilling has generated an increase in
Exhibit 3. Rising Well Backlog Supported By Comments
Source: EIA, API, PPHB
work. And as Dr. Lewis confirmed, the growth in demand has exceeded the service industry's ability to satisfy it. Last November, we attempted to try to gauge the number of drilled but uncompleted wells as we felt that phenomenon could depress natural gas prices as the wells were completed and the production volumes hit the market, even if new well drilling declined.
As the chart from the study (not updated) shows, we expected the industry to reduce its backlog of uncompleted wells as we moved into the first quarter of this year, but then the backlog would begin growing even with higher prices for hydraulic fracturing services. While we are not sure whether our number of drilled but uncompleted wells is close to the actual number, based on Dr. Lewis's comments, our well backlog pattern appears correct. That cannot be a good sign for future natural gas prices since the drilling rig count has continued to rise, including adding another 17 working rigs last week, although only two were targeting natural gas.
Is it possible the gas-oriented rig count is poised to start falling in response to low gas prices? Reportedly, Chesapeake Energy (CHK-NYSE) management told analysts that it was going to deactivate 20 drilling rigs in response to low gas prices. Chesapeake's CEO Aubrey McClendon also said he wished the company had more liquids, meaning more oil. Today, virtually every independent producer wants to be seen as more oily than gassy because oil prices are $80 per barrel and natural gas prices closed Friday at $3.87/Mcf, a value differential of 20.7 to 1, approaching the peak disparity that existed last summer. Maybe this is the first demonstration of capital discipline by a producer.
Exhibit 4. Are Gas Producers Poised To Destroy Capital?
Source: Bernstein Research, Art Berman, PPHB
Based on information contained in a report on the financial health of a group of independent producers issued by Bernstein Research, a universe of 41 companies is spending an average of 128% of its estimated cash flow. If natural gas prices remain low, or fall lower, the companies' cash flows will be reduced. We would anticipate that these companies will need to reduce their capital spending. On average, this universe of companies has a 43% debt to total capitalization ratio, which is not particularly high. However there are at least a half a dozen companies that are spending more than their total cash flow with debt to total capitalization ratios of 50% or greater. Unless natural gas prices rise or producers cut back their drilling, production and spending, the industry is headed for a train wreck resulting in substantial capital destruction.
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