Falling Rig Count Could Cause Natural Gas Production Decline

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Includes: BOIL, DGAZ, MRO, MTDR, SN, UGAZ, UNG
by: HiddenValueInvestor

Summary

EIA data suggests a 25% reduction in the U.S. rig count is required for natural gas production growth to flatten.

U.S. rig count could fall significantly with recent collapse in oil prices.

Demand for natural gas is expected to grow due to EPA mandated coal plant retirements.

U.S. natural gas supply and demand have both steadily risen over the last few years. New discoveries, such as the Marcellus, and associated gas from drilling for oil have been the primary drivers of supply. Industrial demand for natural gas, and the continuing EPA driven retirement of many coal plants, have been the primary movers of demand. A recent Seeking Alpha article by Richard Zeits about a longer term bullish case for natural gas details why demand for natural gas is expected to grow by 18 billion cubic feet per day over the next five years.

Up until now the assumption has been that low cost supply will have no problem keeping up with, or even outstripping, demand. But the recent collapse in oil prices should throw those assumptions overboard. Most exploration and production companies have had drilling budgets well in excess of their cash flow. They have used debt and new equity to supplement the difference. With oil prices dropping in half cash flow for the industry will be greatly diminished. And lenders have lost their appetite for providing new debt to very over-leveraged companies.

The Eagle Ford can be used as an example of how far the rig count needs to fall before growth in natural gas production stalls out and starts to decline. The Energy Information Administration, known as the EIA, publishes a monthly drilling production report tracking the six largest shale plays in the country. Here is a look at the growth in natural gas production over the last few years from the Eagle Ford region:

The chart demonstrates that the Eagle Ford has contributed an increase in daily production of approximately 5 billion cubic feet per day over the last five years. The next chart from the EIA shows the number of rigs actively drilling in this region:

The chart depicts a steady number of around 300 rigs have been actively drilling in the Eagle Ford since 2012. The EIA also estimates that on average each new well in the Eagle Ford produces about 1.2 million cubic feet per day in its first month of operation.

The EIA also has a chart estimating the increase in monthly natural gas supply from new wells and the decline in natural gas production from legacy wells in the region:

Here the EIA is estimating that production from new wells will add 410 billion cubic feet per month in February, and the decline from existing wells will subtract 313 billion cubic feet per month. The additional increase in natural gas is based on an assumption of approximately 300 active rigs in the region. If the rig count in the Eagle Ford were to decline by 25% to around 225 active rigs, then the average production from new wells would decline to 307 billion cubic feet per month wiping the Eagle Ford out as an area of natural gas production growth.

A steeper decline in the rig count would mean the lost production from legacy wells in the Eagle Ford would be greater than the new production from new wells. That would mean total production of natural gas from the Eagle Ford would fall. The picture is similar for the other five regions tracked by the EIA in its report; the Marcellus, Haynesville, Bakken, Permian, and Niobrara.

Multiple companies that drill in the Eagle Ford have already announced plans to reduce their active rigs in 2015. For example, Sanchez Energy (NYSE:SN) has announced plans to cut from 8 rigs in the Eagle Ford in 2014 down to 4 rigs in the Eagle Ford in 2015. Matador Resources (NYSE:MTDR) has announced a reduction from 2 rigs currently to zero rigs in the Eagle Ford later in 2015. Marathon Oil (NYSE:MRO) has announced a 20% overall reduction in capital spending in 2015 versus 2014. Many other Eagle Ford drillers are announcing similar reductions in expected drilling.

A large fall in the U.S. rig count has already started. On January 9, 2015, Baker Hughes announced the U.S. overall rig count fell by 61 rigs in one week to 1,750 rigs. This is lower than the 1,754 rigs drilling one year ago and marks the first year over year decline since oil recovered from the financial crisis in 2009.

Unless oil prices move back towards $75 a large fall in the rig count can be expected in 2015. A 25% reduction in the rig count towards 1,300 rigs would virtually eliminate the growth in the supply of natural gas. Should this happen, then the price of natural gas would have to rise high enough to encourage drilling for dry natural gas outside of the core areas of the Marcellus and the Haynesville. It would probably take natural gas prices above $5 per mcf for a sustained time for this to occur.

According to the EIA weekly natural gas storage report natural gas in storage is below the 5 year average. The natural gas futures market could act very swiftly if the U.S. rig count moves towards 1,300 rigs, or even below 1,300 active rigs.

ETFs To Which Natural Gas Fundamentals Are Relevant:

  • The United States Natural Gas ETF, LP (NYSEARCA:UNG)
  • VelocityShares 3x Inverse Natural Gas ETN (NYSEARCA:DGAZ)
  • VelocityShares 3x Long Natural Gas ETN (NYSEARCA:UGAZ)
  • ProShares Ultra Bloomberg Natural Gas ETF (NYSEARCA:BOIL)

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.