In July of 2008, the natural gas drilling rig count rose to a peak of 1505 rigs in response to natural gas prices in excess of $13 per MMBtu. As prices fell to below $4 per MMBtu, the rig count responded, falling to 665 just one year later in July, 2009. However, this trend seems to have been broken, since even with prices hovering below $4 per MMBtu for weeks on end, the rig count has again started to climb.
According to Baker Hughes, the number of rigs actively searching for natural gas rose to 898 as of August 26th, 2011. This is up substantially from two years ago. But where is the incentive to drill at sub-$4 per MMBtu levels? The answer is natural gas liquids, or NGLs.
NGLs are priced in accordance with crude oil prices. The price of a barrel of NGLs is based on what is considered a normal mix. (The pie chart to the right shows the typical composition of one barrel of NGLs recovered from a natural gas well.) As crude oil prices have risen, the value of NGLs in the natural gas production process has increased accordingly. As a result, producers are not responding to falling prices by curtailing production the way they have historically. Instead, producers are idling rigs in gas basins with lower NGLs and focusing primarily on shale plays that are liquid-rich, i.e.those that contain a higher percentage of NGLs. Many of these liquid-rich shale plays still contain a substantial amount of natural gas.
NGLs have always been part of the natural gas production process. Historically, natural gas prices followed the trend of crude oil. So as crude oil prices rose, so too did natural gas prices, making the benefits of NGLs less prevalent. Today, however, the price link between crude oil and natural gas no longer exists, and natural gas prices have fallen while crude oil prices have risen. This has increased the benefits of NGLs in the natural gas production process.
High cost NGLs are probably the number one driver behind rising natural gas production levels, because higher NGLs lead to lower natural gas break-even prices. For example, a natural gas well that is drier (one that contains few NGLs) may have a natural gas break-even price in the range of $4-$5 per MMBtu. By comparison, a natural gas well that is wetter (one that contains a higher level of NGLs) will have a lower break-even point. The level of NGLs present in wells varies from play to play, which is why break-even points differ based on location. For example, it is estimated that there are about 2.9 gallons of recoverable NGLs per Mcf of natural gas in the regions of the Marcellus Shale, and the break-even price for the natural gas in these regions is estimated at $3.17 per Mcf. Another example is the Eagle Ford Shale, which is considered one of the most liquid-rich plays in the nation. Here, the break-even price for natural gas is estimated at $1.67 per Mcf. And in the Permian Basin, due to the extremely high NGL concentration, some companies are producing associated natural gas essentially for free; the sale of crude oil and NGLs allows them to give the gas away at no cost and still be profitable.
With NGLs, the price of natural gas alone is somewhat irrelevant to whether producers will continue to search for natural gas. Instead, the price driver seems to be the correlation between crude oil prices and NGLs. So long as crude oil prices remain high and NGLs continue to be priced in accordance with crude, natural gas producers will continue to flock to liquid-rich shale plays. This means that they will continue to produce natural gas, even if prices remain where they are at, because the benefits of NGLs make it possible for producers to accept a lower price for natural gas without taking a cut to profits.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.