On Friday, the Energy Information Administration (EIA) released natural gas production statistics for the month of June and revised statistics for May. The report will again disappoint those analysts and industry insiders who have predicted an imminent drop off in US natural gas supply in response to the dramatic decline in gas prices during the first half of the year. In defiance of the sub-$2 NYMEX natural gas lows registered in April and continued steep decline in gas-directed rig count, the Lower 48 States' natural gas production remained essentially unchanged in May and June.
The Lower 48 production declined in June from May by an almost negligible 0.18 Bcf/d or 0.2%. The production shut-ins in the Gulf of Mexico due to Tropical Storm Debby largely accounted for the decline. The revised May data shows a slight increase in production from April. The Lower 48 natural gas production remained essentially flat from November last year through June (the latest data available). I argued in my earlier note that the natural gas industry is producing at levels exceeding demand, which is manifest in the strong build-up of storage levels and very high backlog of drilled wells waiting on completion or pipeline connection. The flat production figures indicate that the supply/demand balance was still not achieved in June, despite the highly unattractive economics of the dry gas drilling.
The report highlights the continued trend of the Marcellus shale production gradually displacing volumes from less economic regions. The Other States gross withdrawals (the key growth behind which is the Marcellus shale) increased by a remarkable 1.9 Bcf/d during the seven-month period from November last year to June this year. The June numbers indicate that the growth trend continued unabated (Other States gross withdrawals increased by 120 MMcf/d in June and 400 MMcf/d in May).
What may come as a surprise is the distinct decline trend in the Wyoming production (which includes the prolific Pinedale and Jonah fields). The Pinedale has been broadly perceived in the industry and among investors as one of the lowest cost fields in the United States. Recent decisions by Ultra Petroleum Corp. (NYSE:UPL), one of the larger operators in the Pinedale, to significantly reduce its completions activity in the Pinedale may cast doubt on the cost of supply economics from the field relative to other regions.
A month ago, I argued in several of my notes that the strong drop off in the natural gas rig count does not readily translate in the decline in the natural gas production. Several factors are contributing:
- A significant backlog of curtailed or shut in production from earlier in the year that will need to find its way to the market once the injection season is over. Two companies alone, Chesapeake Energy Corporation (NYSE:CHK) and Encana Corporation (NYSE:ECA), had estimated combined gross operated production of 1.3-1.4 Bcf/d shut in or curtailed during the first half of the year. Chesapeake has guided that it intends to reverse its production curtailments during the next two quarters, which should lead to its natural gas production peaking before the end of the year at a level that is 12% higher than the company's average production during Q2.
- A significant inventory of wells waiting on completions or pipeline connections. Some of the backlog is explained by the infrastructure constraints in the growing producing areas such as the Marcellus and the Eagle Ford. As the bottlenecks are being resolved, the backlog wells will gradually come online. Most notably, the excess well inventory also reflects deliberate decisions by operators to defer well completions and tie-ins until the expected price recovery in the second half of the year, effectively creating "rig-independent" supply.
- Improving well performance and rig productivity. As operators focus on drilling only the very best dry gas wells due to the depressed price environment, production per rig is increasing. Productivity gains from the high-graded rig fleet and pad drilling are another important contributing factor.
- Rapid growth of liquids-rich and associated gas volumes. The rate of growth from this important source of natural gas supply appears to be underestimated by many Wall Street analysts and industry insiders, same way the volume growth from the Haynesville shale and the Marcellus shale was grossly underestimated just two or three years ago.
Looking forward, all these factors will contribute to a delayed and shallower decline in the US natural gas production than may appear. As a result, natural gas prices will likely remain vulnerable to corrections until the massive production backlog from various sources is absorbed. These fundamentals have implications for natural gas producer stocks that as a group appear to price in a meaningful recovery in natural gas prices. While in the longer run a return to more economic natural gas price levels is inevitable, the recovery may not be as imminent as often predicted. This fundamental dynamic is most relevant to stocks with natural gas focus and high financial leverage.
My natural gas producer index includes the following companies: Chesapeake Energy, Encana Corporation, Devon Energy (NYSE:DVN), Southwestern Energy (NYSE:SWN), Ultra Petroleum, EXCO Resources (NYSE:XCO), WPX Energy (NYSE:WPX), Cabot Oil & Gas (NYSE:COG), Range Resources (NYSE:RRC), QEP Resources (NYSE:QEP), Quicksilver Resources (NYSE:KWK), and Forest Oil (NYSE:FST).