Back To The Haynesville? - Conflicting Views From Chesapeake And Encana

Includes: CHK, ECA, EOG, QEP, SM, UNG
by: Josh Young

Encana (NYSE:ECA) announced recently that it has resumed drilling in the Haynesville: "Because of the low supply costs in this play, Encana expects that the Haynesville will be able to produce solid returns at current natural gas prices. The company currently has two rigs running in the play with plans to increase to five rigs through 2013."

This is surprising, because another company with meaningful exposure to the Haynesville play, Chesapeake Energy (NYSE:CHK), recently discussed drilling economics in gas plays with investors, and said that it expects production declines from the Hayenesville, as the play requires $4.75 natural gas prices for a 15% IRR. It did mention that those numbers are not precise, and that there could be some locations in the Haynesville and Barnett that could be economic at current natural gas prices. But with that kind of caveat, one might expect one or two rigs running across the play, not 2 rigs ramping to 5 just by Encana.

It is obviously bearish for natural gas prices (NYSEARCA:UNG) for drilling rigs to return to the Haynesville. The question is, are other companies also returning rigs to the Haynesville? This will be driven by another question: is this more drilling to hold leases by production and/or to stem production declines, or is it truly economically driven? If the typical well in the Haynesville requires ~$4.75 natural gas for a ~15% IRR, then perhaps the best wells might achieve a 15-20% IRR at the current ~$3.25 natural gas price. That kind of return should be insufficient to attract capital based solely on economics.

Typically, E&P companies seek higher well-level rates of return, as when overhead and infrastructure costs are factored in, the true corporate rate of return is generally substantially lower. It is rare to see significant capital deployed at below 30% IRRs at the well level. In the past few years, programs targeting those lower rates of return have only taken place in natural gas fields, where companies were betting on higher gas prices in the future, felt compelled to hold acreage by production, or to stem production declines and stay within debt covenants.

One way we will tell if the economics are compelling is if companies with well-known, high rate of return oil plays pull capital away from those plays and redeploy it to the Haynesville. Companies like QEP (NYSE:QEP), SM Energy (NYSE:SM) and EOG (NYSE:EOG) have cut their Haynesville rigs to deploy capital elsewhere, and each has exposure to the Bakken and/or the Eagle Ford as well as to the Haynesville. If these companies and others bring rigs back to the Haynesville, perhaps then we will know the play is economic.

However, these companies are not indicating a return of rigs to the Haynesville, and overall, the natural gas-oriented rig count is not rising rapidly. Since we are not seeing this return of rigs industrywide to the Haynesville, perhaps Encana is an exception, and perhaps its increased Haynesville activity is driven more to stem production declines, or due to a lack of alternative economically attractive projects than by improved economics from the play. One other possibility is that Encana could be predicting higher future natural gas prices, which would make drilling activity more economic as the company ramps its active rigs in the play from 2 to 5 over the course of the year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.