Is Anyone Still Drilling for Natural Gas?

While the price of natural gas is low in North America due to a vast abundance of supply, the same is not true in the rest of the world. That dynamic has been captured by the rig counts all over the world. When prices are good, companies drill oil and gas to earn what they believe to be a solid rate of return. When prices for oil and gas fall too far, they no longer provide sufficient returns to justify drilling for them.

One company I love following to get a pulse on oil and gas capital spending worldwide is Baker Hughes (NYSE: BHI  ) , since it publishes very helpful rig count information that helps track the trend of oil and gas drilling worldwide. In the North American market, Baker Hughes continues to see the shift in rigs from gas to oil. In the fourth quarter, gas rigs comprised 42% of the total North American rig count, down from 54% a year earlier. Further, the company expects gas rigs to decline by 218 rigs by the end of 2012, which contrasts sharply with the expected increase in oil rigs by 220 rigs.

While the outlook for a region like Europe is understandably cloudy given the debt situation, Baker Hughes predicts rosier outlooks for some other regions. For example, the Latin American rig count is forecast to climb about 13%, the Middle East and Asia Pacific rig counts should climb by about 9%. It's worth examining some of the players in the North American onshore market to see if the disparity in rig counts makes sense.

The North American picture
While global behemoths like ExxonMobil and Anadarko -- two of the top five producers of natural gas in the U.S. -- aren't likely to drastically alter their overall oil and gas mix just because natural gas is hitting lows in North America, independents focused on the onshore U.S. and Canadian markets are likely to act differently. Chesapeake Energy (NYSE: CHK  ) and Devon Energy (NYSE: DVN  ) , the second and fourth largest natural gas producers in the U.S. respectively, are two such companies.

Just last week, Chesapeake announced it would reduce its dry gas rig counts from 47 down to 24 by the second quarter. The company averaged 75 gas rigs in 2011, but that number's likely to average well below 40 in 2012 given the pace of the company's ramp down. For the full year, the company expects to reduce dry gas capex 70% net of drilling carries and even shut-in 0.5 Bcf per day of production.

Like Chesapeake, Devon has been shifting its mix toward liquids. Devon's assets span much of the U.S. and Canada, where it holds almost 13 million acres. The company's reserves are currently 40% liquids and 60% natural gas, a balanced mix that's skewed a bit toward natural gas. However, the company allocated more than 90% of its capital spending toward oil and liquids-rich projects. Devon doesn't have much expiring acreage, so it has the flexibility to allocate capital depending on market conditions. I expect Devon to maintain its focus on liquids in its 2012 capital spending program.

In addition to the liquids focus among the larger players, the shift is happening among smaller independents as well. Carrizo Oil & Gas (Nasdaq: CRZO  ) , a company with a balanced portfolio of assets that includes the Eagle Ford Shale, the Niobrara Shale, Barnett Shale, and Marcellus Shale. For the full year, Carrizo expects to spend about 67% of its drilling capex on liquids, a much heavier mix than in 2010, when the Barnett Shale made up the majority of its spending. The company estimates that about 70% of its 2012 U.S. capital spending program will be spent on the Eagle Ford and Niobrara, which would signal continued focus on its liquids-rich Niobrara and Eagle Ford plays.

Most, but not all
However, there are exceptions. There are companies that are low-cost producers of natural gas and able to make a profit even at extremely low gas prices. Ultra Petroleum (NYSE: UPL  ) falls into this camp. In the third quarter, natural gas made up 96.3% of Ultra's total production. While the company hopes to add oil production through its Niobrara acreage in the future, this is still in the exploratory stage.

Meanwhile, the company continues to increase its natural gas production. The company's expected production is 245 Bcfe in 2011. Over the next two years, the company hopes to produce 290 Bcfe in 2012 and 330 Bcfe in 2013. The company's production comes mainly from the gassy Pinedale and Jonah Fields in Wyoming and the Marcellus Shale areas. While other companies focus on shifting toward liquids, Ultra has no problem increasing its gas production.

The way Ultra does this is by keeping costs down, and that means increasing drilling efficiencies. In the Pinedale Field, the company has reduced its spud to total depth by 66% since 2007, while also reducing its rig release to rig release measured in days by 69%. This leads to lower well costs on a per-well basis and also reduces all-in costs per mcfe, which helps maintain its low-cost status.

Finally, the company has hedged 129.1 Bcf of production volume for 2012 at an average price of $5.02 per MMbtu. This greatly increases the average realized price in today's environment, helping Ultra continue producing despite rock-bottom prices.

Foolish bottom line
While Ultra has done a nice job keeping its costs down and continuing to increase natural gas production, it's the exception, not the rule. If natural gas prices continue to stay low, the gas rig count should further decline in 2013 after what is expected to be a pretty big decline in 2012. The gas rig count likely won't increase again unless the price of natural gas goes back up. When that happens, of course, is anyone's guess.

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Paul Chi is an analyst on the Fool's Alpha and Duke Street services. You can follow him on Twitter to stay up-to-date on his latest market commentary. Paul and Matt Argersinger co-manage the Street Fighter portfolio, where they look for cheap, unloved stocks with home run potential. Paul owns shares of Chesapeake Energy. The Motley Fool owns shares of Ultra Petroleum and Devon Energy. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy and Ultra Petroleum. 

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  • Report this Comment On February 01, 2012, at 12:10 AM, MHedgeFundTrader wrote:

    Natural gas finally got some good news last week. First, major producer, Chesapeake Energy (CHK) announced that it was cutting its natural gas production by 50%, taking some immediate pressure off the market. Sure, (CHK) is just one company, but others may follow suit.

    Second, at the urging of my friend, Boone Pickens, Present Obama announced funding of some natural gas corridors in his State of the Union address. These are chains of natural gas stations placed every 100 miles stretching from east to west and north to south that would allow heavy trucks on transcontinental routes to refuel. This would provide the extra incentive for these 18 wheelers to convert from diesel fuel to CH4 at a nominal cost and put a major dent in our oil imports.

    The news was enough to trigger a massive short covering rally in this most unloved of molecules. The spot market soared 25%, from $2.25 to $2.82 per MBTU’s, while the ETF (UNG) leapt from $5 to $6.

    I am going to call the bluff of the market here and buy the United States Natural Gas Fund April, 2012 $6 puts at $0.65 or best. That way I can take advantage of the huge contango that exists between the spot and forward markets for natural gas futures contracts. To avoid actually drilling its own wells, the (UNG) buys forward contracts at huge premiums and holds them until they expire at spot. They then roll the cash forward into new contracts and repeat the process. It is one of the best wealth destruction machines I have ever seen and explains why (UNG) has, by far, outperformed natural gas on the downside. It is a great thing to be short.

    The Mad Hedge Fund Trader

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