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When Will Energy Companies Start Drilling for Natural Gas Again?

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Over the past couple of years, one of the most obvious trends in the energy exploration and production business has been the shift away from drilling for natural gas and toward drilling for oil and, to a lesser degree, gas liquids.

It all boils down to price. With natural gas prices at under $4 per MMBtu, most energy companies simply had no financial incentive to produce the out-of-favor commodity. And when prices dipped below $2 per MMBtu last spring, virtually every energy producer that was still drilling for natural gas was taking sizable losses.

But things are finally looking up. Natural gas prices have seen a general upward trend since bottoming out in April last year, as many analysts argued they would. Since the middle of February, prices are up by nearly 25%.

So why aren't energy companies rushing into gassier plays?

Is gas too cheap to produce?
The short answer is that oil production is still much more profitable than natural gas production. Despite the recent surge in gas prices and decline in oil prices, oil remains about six times more expensive than natural gas on an energy equivalent basis.

Hence, energy companies with the flexibility of migrating their rigs toward oilier plays will continue to do so as long as oil production remains more profitable. This raises the next crucial question -- at what price level is it profitable for energy companies to produce natural gas?

That's tough to say because the economics of various gas formations differ considerably, depending on such factors as the play's geology, subsurface pressures, and the level of pipeline and gathering infrastructure.  

For instance, some producers drilling in the Marcellus shale of Pennsylvania -- a play widely recognized as the most economical in the country -- can reportedly turn a profit with prices just north of $3 per MMBtu. But other gas plays aren't economical unless prices are twice that level or more.

Anadarko's (NYSE: APC  ) drilling program in the Marcellus is instructive. For the company's Marcellus operations to be economically viable -- i.e., deliver a 20% pre-tax rate of return on drilling -- gas prices need to be at least $3.25 per MMBtu.  

But just because a drilling program is economically viable doesn't mean the company will immediately begin to allocate capital toward it. For that to happen, it has to offer a rate of return that's attractive relative to the company's other opportunities. In Anadarko's case, natural gas prices would have to climb above roughly $4.25 per MMBtu for the Marcellus to start diverting investment away from the company's other projects.  

That leads to the final crucial consideration to help answer the question posed at the beginning -- breakeven prices for different natural gas producers.

Breakeven prices for gas producers
With gas prices currently above $4.25 per MMBtu, the companies most likely to resume or commence gas drilling are the ones that can turn a profit at those prices -- low-cost producers, in other words. According to an analysis by Wells Fargo, Ultra Petroleum (NASDAQOTH: UPLMQ  ) , Chesapeake Energy (NYSE: CHK  ) , Devon Energy (NYSE: DVN  ) , and Apache (NYSE: APA  ) were among the industry's lowest-cost producers last year.

Ultra, Chesapeake, and Devon could all produce gas profitably at prices under $5 per Mcf, while Apache required prices a little north of $6, as measured by their all-in costs per Mcfe.  Surprisingly, however, neither Chesapeake nor Devon has expressed any desire to resume or accelerate gas drilling any time soon, despite the recent surge in prices.

Chesapeake's chief operating officer and acting CEO, Steve Dixon, recently said that the company will focus primarily on ramping up production in the liquids-rich Eagle Ford shale of Texas, while Devon plans to allocate much of its capital budget toward drilling for oil in the Permian Basin.  

Final thoughts
As you can see, even some of the industry's lowest-cost producers are opting not to resume or accelerate gas drilling until prices rise further. As to what that price level is, my guess would be at least $5-$6 per MMBtu, assuming the price of oil stays relatively constant at around $100 per barrel. That means we'll probably have to wait a good while longer before companies start to divert resources away from oily plays toward gassy ones.

As natural gas prices climb higher over the next few years -- a likely prospect -- Chesapeake Energy stands to gain big time. Though the company has allocated the majority of its capital this year toward drilling in liquids-rich plays, natural gas still makes up more than three-quarters of the company's production mix. Will the company be able to ramp up oil production and survive until natural gas prices finally recover? Or will it languish under the weight of its heavy debt load? To answer that question and to learn more about Chesapeake and its enormous potential, you're invited to check out The Motley Fool's brand-new premium report on the company. Simply click here now to access your copy, and, as a bonus, you'll receive a full year of key updates and expert guidance as news continues to develop.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 22, 2014, at 2:01 PM, flyodrao wrote:

    What perplexes me about the low-cost analysis, is that Southwestern Energy has a presentation on its website where it claims to be among the low-cost producers, but doesn't mention UltraPetroluem and vice-versa. Not sure why. It would be good to let us know why.

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