U.S. Rig Count And Energy Prices, Part 2: 2015 Natural Gas Price Range $2.5-$4.5

|
Includes: AREX, REXX, SBOW, UNG
by: Energy Solutions Partners

Summary

Pricing of natural gas responds to demand or supply shocks.

Large US rig count declines are followed by rising natural gas prices with a 10 month lag.

2015 natural gas price range: $2.5 – $4.5 MMBTU.

This is part 2 of my US rig count article. Part 1 can be viewed here.

In September of 2008 natural gas prices were over $8 mmbtu, and the US rig count had moved up to about 2,000 due to this higher pricing environment.

At this time 1600 rigs were directed natural gas drilling while about 400 were for oil. This was about a 15% increase in drilling rigs for natural gas from the prior year. Also oil directed drilling had increased over 30% due to the start of fracking for oil, and higher premiums for liquids.

This is important due to the associated natural gas that gets produced from oil drilling. Read this EIA Nov. 23rd, 2011 report on associated gas produced in the Bakken of North Dakota. Over 33% at that time had to be flared, since it could not be marketed. Here is some text from that report:

"Natural gas production in North Dakota has more than doubled since 2005, largely due to associated natural gas from the growing oil production in the Bakken shale formation. Gas production averaged over 485 million cubic feet per day (MMcfd) in September 2011, compared to the 2005 average of about 160 MMcfd.

However, due to insufficient natural gas pipeline capacity and processing facilities in the Bakken shale region, over 35% of North Dakota's natural gas production so far in 2011 has been flared or otherwise not marketed. (It is generally better to flare natural gas than to vent it into the atmosphere because natural gas-methane-is a much more powerful greenhouse gas than carbon dioxide.) The percentage of flared gas in North Dakota is considerably higher than the national average; in 2009, less than 1% of natural gas produced in the United States was vented or flared. "

Back to 2008/2009 time frame

In the fall of 2008 we had the huge demand shock caused by the great recession. After seeing the sharp decline in oil and natural gas prices, oil and gas exploration firms started cutting capital expenditures, and the rig count started to fall. My thesis for natural gas price response to changes in US rig counts is that we need to look at total rig count changes, more than just the number of rigs drilling for natural gas.

As stated above the amount of natural gas produced form oil drilling is significant. So reductions from either oil or natural gas directed rigs will lead to lower natural gas production and hence rising natural gas pricing.

In Oct and Nov of 2008, the fall in rig count was slow, as it takes a few months for short term drilling contracts to expire, and drilling activities to be completed for individual wells. In these 2 months the average weekly decline was about 15 rigs.

But starting in Dec. 2008 we saw one of the largest declines in rig count with 28 consecutive weeks of declines (except early April 2009 were a total of 4 rigs were added). The USA rig count declined by about 1,000 rigs in those 28 weeks. So on June 19th the US rig count had fallen to below 900 active rigs in the US.

With much lower drilling activity, one would expect oil and gas production to fall as well. The key question would be how long is the lag between the falling rig counts and actual production rate declines? We could look back to the similar fall in energy prices back in late 2008. Let's first understand what current drilling well production curves look like:

The above chart is significant since it demonstrates the extremely high production of natural gas in the first 3 or 4 months of production. So when less new drilling occurs, we should see a rapid decline in future production rates.

Price response to lower rig counts

In Sept. of 2008 natural gas prices started falling sharply. In the summer of 2008, natural gas prices were over $10, but by October 2008 the price had fallen to $5.6 close to a 50% reduction is well head prices. Natural gas prices continued to fall in 2009, hitting a low below $3 in Sept of 2009.

On Nov. 26th 2008, the USA rig count fell by 75 rigs. We then witnessed the continued large fall in rig counts for the next 5 months.

The key question for investor's would be: when does this sharp fall in drilling activities lead to decreased production rates and increases in prices? As stated in part 1 of my rig count article, oil prices bottomed and started to climb before June of 2009. For natural gas prices in 2008/2009 we saw the same phenomena, but with a longer lag period.

The data shows that from lows below $3 during the Sept. 2009, prices started to rise above $5 in Jan. 2010, and stay above $4 for the year.

To summarize the 2008 and early 2009 timeframe:

  1. Natural gas price correction confirmed in Sept. 2008.
  2. Rig count correction confirmed Dec 2008 - 2 month lag.
  3. Natural gas price recovery confirmed Oct 2009 - 10 month lag.

Conclusions and 2015 natural gas price range.

As we can see from the above chart, total rig counts are now rapidly falling. Natural gas pricing dynamics are a bit more complex than oil. Read my article about longer term natural gas prices due to changes in demand and well as supply. Given the longer price lag of about 10 months, I do not think we will see natural gas prices start to rise until Aug. or Sept. of this year.

My price range for 2015 is $2.5 - $4.5. My estimate is for prices to rise to about $4.5 by the end of the year.

To summarize the 2015 timeframe:

  1. Natural gas price correction confirmed in Nov/Dec. 2014 - Check!
  2. Rig count correction confirmed Jan/Feb 2015 - 2 month lag - Check!
  3. Natural gas price recovery confirmed Sept 2015 - to be discussed and confirmed.

Investment strategy for 2015

Based on the above price recovery timeframe, my strategy will be to ladder into several small natural gas producers that have hedges in place for 2015, or are trading at extremely low valuations. I generally ladder into a position in 25% increments. My criteria for these investments are:

  1. Small cap stocks, typically less than 1 billion. These smaller names are also the most beaten down due to the oil price correction. Also most have a higher short %. Finally since these firms will have a low enterprise value, they can be acquisition targets.
  2. Solid 2015 hedges in place. This will help these small cap firms survive this current low oil pricing environment.
  3. High short % - over 20%. If my thesis proves out to be correct, I want maximum upside. For many smaller oil and gas explorations firm, we could see some massive short squeezes if oil prices recovery.
  4. Low price to book ratios. Again if oil prices recovery, many of these firms will see their respective market caps return to book value or even above book.
  5. Reasonable debt to equity ratios - 100% or lower. Similar to hedges, these lower debt ratios give these firms some breathing room to wait out this lower oil pricing environment.

My current picks:

Approach Resources (NASDAQ:AREX)

Swift Energy (SFY)

Rex Energy Corporation (NASDAQ:REXX)

Stock

Price/Book

2015 oil hedge %

Short %

Market Cap(M)

Debt/Equity

Cash flow/Cap %

AREX

33%

64%

27%

257

46%

59%

SFY

9%

0%

35%

95

99%

300%

REXX

23%

70%

25%

137

115%

96%

Of these 3 equities, AREX would be my favorite. AREX has a compelling combination of low P/B, high short interest, low D/E, strong cash flows, and well hedged for 2015. REXX is compelling for the same reasons.

SFY is a highly speculative pick, due to its weak balance sheet, and lack of hedging. A safer approach may be to buy SFY's bonds that are trading well below 50%. But SFY stock has the most potential upside going forward due to being valued at less than 10% of net asset value, high short interest, high cash flow, and a nice mix of oil, natural Gas, and condensates in the Eagle Ford formation of TX.

Disclosure: The author is long AREX, SFY.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.