The key argument often used by natural gas bulls is that the dramatic reduction in rig counts in the dry gas producing shales will translate into a rapid drop off in supply and lead to the price recovery toward the $5 level, and possibly higher. The Haynesville shale, where the rig count has declined from the peak of over 180 rigs two years ago to approximately 27 currently, is often presented as the most compelling evidence supporting that argument.
The view has been advocated by several prominent industry CEOs, including Chesapeake's Aubrey McClendon and Ultra Petroleum's (UPL) Michael Watford. During Ultra's 2Q earnings conference call on August 2, Michael Watford re-iterated his macro perspective on natural gas: "Capital is being withdrawn from natural gas investment as seen in the rig count reduction and pressure pumping softness. Production lags capital expenditures and the decline in production is imminent. We see $4 gas in 2013 and $5 gas in 2014." With regard to Haynesville specifically, he commented: "We have a view that says: production supply is about to shrink pretty rapidly. I think there are some comments out yesterday, with some companies that announced and talked about the Haynesville, that they would see a 10% per quarter reduction in their production. I think it is plus or minus 40% for the year. If you apply that to the 6 Bcf per day of Haynesville production, it is 2.5 Bcf per day of annual rate reduction, so I think we are about to see a drop off in supply." Michael Watford was referring to the earnings call remarks by QEP Resources (QEP) the night before.
2.5 Bcf per day is a big number, particularly given that Haynesville is just one producing field of many, albeit a significant one. If that rationale held, the $5 natural gas outlook would probably be conservative. However, a more rigorous look at the Haynesville operating data leads to somewhat different conclusions.
In less than four years since its discovery announcement, the Haynesville production went from zero to almost 7 Bcf per day, by some industry estimates, or over 10% of the total US natural gas production, demonstrating the exceptional productivity of this field as well as the scalability of the supporting operational infrastructure including oilfield services, gathering systems, and pipeline off-take. The rig count peaked at about 186 rigs during the summer of 2010 but has been in a steady decline ever since. There are currently approximately 27 rigs working in the play, about evenly split between the Louisiana and Texas portions of the play. Of these rigs, approximately 11 rigs, including 8 run by Anadarko (APC), are focusing on the liquids-rich part of the Haynesville, mostly in Panola County of Texas. The other approximately 16 rigs are targeting dry gas.
Based on the analysis of the well distribution profile by vintage, I estimate that the field-wide base production decline is currently in the 2.5%-3.0% per month range. Applying the decline rate to the estimated base production of 6.5 Bcf/d, the base production drop off equates to 165-195 MMcf/d per month. How many new wells per month would it take to offset the base decline?
For illustrative purposes, let's assume that half of all wells are being completed in the liquids-rich area or in the less productive Tier II part of the play (to hold acreage) with an average first-month restricted dry gas flow rate of 4.5 MMcf/d per well, while the other half of the completions are concentrated in the dry gas sweet spots and flow at an average first-month restricted rate of 7.5 MMcf/d (my analysis of recent completions data leads me to believe that these assumptions are conservative). This translates into a total of 27 to 33 wells that need to be put in-line per month to maintain the base production flat. In a pad development mode, one rig can yield as many as 10 wells per year. In the delineation mode, rig productivity is lower and I assume a yield of 8 wells per rig-year. These calculations result in a total of 36 to 45 rigs required to keep the production flat, assuming no completions are deferred. These figures will likely decline with time as the operational productivity and completion techniques continue to improve.
The graph below illustrates this analysis. It shows the number of wells added to the "producing" category for the past two years in the Louisiana part of the play (the Louisiana Haynesville data are more available and consistent than the Texas Haynesville data). During that period, the producing well count in the Louisiana Haynesville went from approximately 570 at the end of July 2010 to approximately 2,038 at the end of July 2012. Data is subject to frequent adjustments and reporting delays and therefore should be thought of as approximate. The red line on the graph shows the calculated number of wells that would have been required to be brought to sales during each month in order to keep the Louisiana Haynesville production flat at that time.
During the period from August 2010 through January 2011, the number of new producing wells averaged over 70 per month, or four times the minimum number of new wells required to keep the production flat. As a result, during that period the aggregate production from the field showed strong growth.
Well additions slowed in February 2012 and crossed below the minimum required new wells line in June, for the first time since the field's inception.
The analysis implies that the field's production should have grown all the way through May 2012, although the growth pace would have slowed substantially at the beginning of the year. In actuality, Haynesville pipeline deliveries peaked in November-December last year, with the field's production declining by approximately 0.5 Bcf/d during the first quarter. The difference to the model is explained most likely by the January 2012 decision by Chesapeake (CHK), the largest operator in the field, to curtail as much as 1.0 Bcf/d of its Haynesville and Barnett production throughout the year, with as much as 0.5 Bcf per day curtailed in January or possibly even earlier. Also in January, Chesapeake announced the decision to defer new well completions and pipeline connections whenever possible. Other operators may have joined Chesapeake with similar measures as natural gas prices continued to roll over.
Another important factor in this equation is the inventory of wells waiting on completion or pipeline connection. In the Louisiana part of the play that number stood at approximately 250 wells at the end of July 2012, according to Louisiana Department of Natural Resources (LDNR). In light of the math presented above, this is a significant backlog. Assuming for illustrative purposes that 100 wells, or 40% of the total inventory, will be brought to sales within the next 12 months, the rig requirement is effectively reduced by approximately 10 rigs during that period. While the backlog in the Texas portion of the field is difficult to estimate, it is clear that it is also sizeable.
The staggering conclusion of this analysis is that the 27 rigs currently working in the Haynesville, in combination with some reduction in the drilled but not producing well backlog and the unwind of the production curtailments, may be sufficient to keep Haynesville production at its current level for at least a year, or even longer.
The natural gas industry needs the Haynesville and other dry gas fields to reduce their contribution to the total supply so that the rapid production growth from the more profitable liquids-rich areas can be accommodated. Therefore, more rigs must go on the sideline in the Haynesville and elsewhere so that the production can show tangible declines. That is unlikely to happen with natural gas prices above $4. At that price, dry gas sweet spots in the Haynesville can deliver solid returns (30%+ IRR at the well level, in my estimate). The liquids-rich part of the field will be even more profitable. In addition, the economics of the play will likely continue to improve, due in part to the lower services cost, but more importantly, as a result of the better wells being drilled. Encana (ECA) reports that it has already reached its cost of supply target in Haynesville and can drill economic wells (9% rate of return) even at $3 Henry Hub.
With the well productivity like in the Haynesville, $5 natural gas may not be a realistic economic assumption for the foreseeable future. $4 may also prove to be unsustainable, despite the recent strength of the forward curve.
Currently active rig count in the Haynesville shale by operator:
- Anadarko Petroleum: 8 rigs
- Exco Resources (XCO): 5 rigs
- Petrohawk / BHP Billiton (BHP): 5 rigs
- XTO Energy/ExxonMobil (XOM): 4 rigs
- Chesapeake Energy: 2 rigs
- EOG Resources (EOG): 1 rig
- Royal Dutch Shell (RDS.A): 1 rig
- Valence Operating (private): 1 rig
Most active operators in the Louisiana portion of the Haynesville shale by the number of producing wells to date (% of total):
- Chesapeake Energy / JVs with Plains Exploration (PXP) and Goodrich Petroleum (GDP): 30%
- Petrohawk / BHP Billiton: 11%
- EXCO Resources: 11%
- Encana: 11%
- Royal Dutch Shell : 6%
- QEP Resources: 5%
- Comstock Resources (CRK): 5%
- El Paso / Apollo Group (APO): 5%
- EOG Resources : 2%
Companies that have substantial leaseholds in the play but have no rigs running at the moment:
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.