Natural Gas - Is The Rig Count Finally A Proxy For Production?

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Includes: UGAZ, UNG
by: Dallas Salazar

Summary

The US natural gas rig count continues to be productive for those assuming natural gas finishes the year much higher than its most recent NYMEX close.

Simply to get back to breakeven (using the current T12M spot pricing) natural gas would need to increase 55%.

So then, what happens if we continue to see the natural gas rig count move lower and lower?

A reduction in rigs should mean a reduction in total production, right?

I think so; I make the case that the natural gas rig count has finally reached an inflection point that should allow it to proxy production, finally.

The US natural gas rig count continues to be productive for those assuming natural gas finishes the year much higher than its most recent NYMEX close of $2.84 - up $0.02 on the day, up $0.11 on the T30D, and down $1.57 (37%) T12M. Simply to get back to breakeven (using the current T12M spot pricing) natural gas would need to increase 55%.

Natural gas E&P players, in stark contrast to the foolishness being displayed by US oil E&P players, have been more than measured in their more recent commentary at analyst and investor conferences and in prepared remarks given in mid-quarter corporate updates. This is a marked step back from even Q4/14 earnings reporting and even more exaggerated step back from rhetoric used at Q3 corporate update rounds.

Simply put, natural gas E&P has slowly walked itself, its investors, and analyst/market expectations down in an orderly fashion. Some of the better positioned players, with their solid balance sheets and ability to be opportunistic should the pricing downturn last much longer, have been as bold as to call out that the overall "State of Natural Gas" should get worse before it gets better. I tend to lean into the opinings of those who speak and have nothing to gain from embellishing a situation.

So then, what happens if we continue to see the natural gas rig count move lower and lower?

Well, considering weather has been bearish natural gas demand all year and we've seen somewhat stable demand from power burn a reduction in rigs should mean a reduction in total production, right?

T12M Natural Gas Inventory Reporting1: (SOURCE: eia.gov)

EXPECTATION:

ACTUAL:

DATE:

70 BCF

69 BCF

7/2/15

77 BCF

75 BCF

6/25/15

93 BCF

89 BCF

6/18/15

112 BCF

111 BCF

6/11/15

121 BCF

132 BCF

6/4/15

99 BCF

112 BCF

5/28/15

97 BCF

92 BCF

5/21/15

116 BCF

111 BCF

5/14/15

75 BCF

76 BCF

5/7/15

85 BCF

81 BCF

4/30/15

88 BCF

90 BCF

4/23/15

53 BCF

63 BCF

4/16/15

1bolded figures represent misses to expectations or figures that have been deemed bearish to prop modeling

I think so. And we should in fact continue to see a reduction in rig count based on my analysis of public company management statements and rhetoric, my analysis of the private E&P space - which is really hard to come by, and my analysis of forward looking oil and natural gas pricing.

Taking a look at the T12W natural gas inventory reports you can see that since "injection season" really got into stride that there was a noticeable ramp in production followed by what appears to be an inflection point being reached the week of 6/18/2015. Several factors of course will play into the eventual concrete, hindsight analysis of what caused that (we'll get quite a bit of the information we need to make this analysis at Q2/15 reporting coming up soon) but two factors that can be ruled out as contributors are powerburn and weather.

Again, while powerburn has been elevated from a historic standpoint there hasn't been a sudden deviation from the range that powerburn has been in from a slope line standpoint. Weather, while hard to pinpoint any single source of expectation/realization, has been disappointing and altogether bearish according to my modeling.

That said, I believe the reduction in rig count at current rig count levels will finally act as a proxy for supply side contributions. What do I mean by that? Well, up to this point a reduction in rig count hasn't equated to a reduction in supply - at least I think, again I won't know for sure until Q2/15 E&P reporting. What I do know is that we've been watching the rig count fall, for periods at accelerated rates, and yet injections (and we've already noted that lack of weather has played a role in this) continue to be high and/or greater than expectation. At least they have been until three weeks ago. The last three injection reports, as noted in the table above, have been beats.

I firmly believe that now when we see a week over week rig reduction we should be able to beat the following week at inventory reporting. I believe natural gas E&P has passed an inflection point. I also believe that natural gas may be getting some supply side help from private market M&A - which has picked up substantially, private market bankruptcies - which have picked up substantially, private market suspensions - both to oil and gas, which have picked up substantially, and a prior to this week reduction to domestic oil inventories. All of this helps in a sum of all parts but very zero sum game.

One final bull thesis bullet point to consider, which was brought to me via Twitter by Seeking Alpha natural gas E&P guru Mike Maher, is natural gas exports to Mexico. Maher points out that "exports to Mexico have been averaging ~3.3 BCF/d the last couple weeks, up 40% over the last year". While longer term these exports, I'm sure, will be offset with increased supply in the near-term with spot natural gas pricing being so low and with many players simply looking to survive rather than thrive I expect this to continue to be a tailwind. A nice call out by Maher for sure.

All told we'll need a few more weeks of data to confirm our "inflection point" thesis but it certainly appears based on the last three reports that the rig count could finally proxy what it has historically (pre-highgrading, pre-service company/supplier getting squeezed, pre-E&P taking desperate operational measures) been able to proxy, production.

I continue to believe that natural gas prices significantly higher into year-end. I also continue to recommend a long-position in The United States Natural Gas ETF, LP (NYSEARCA:UNG) and VelocityShares 3x Long Natural Gas ETN (NYSEARCA:UGAZ).

Good luck everybody.

Disclosure: I am/we are long UGAZ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.