Rig Count Vertigo

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By the pace of declines in the natural gas drilling market, you'd think there were pirates prowling the plains of Oklahoma, rather than hanging around the Horn of Africa.

Baker Hughes (NYSE: BHI) today reported that there were fewer U.S. natural gas-directed rigs running this week than at any point in over six years. From its peak in early September, the gas rig count is now down over 52%.

The simple fact is that supply and demand are out of step. Shale players like XTO Energy (NYSE: XTO) and Southwestern Energy (NYSE: SWN) have been hugely successful at unlocking unconventional sources of gas. Thus they were pumping up domestic production volumes just as the economy did its best Wile E. Coyote impression. The only way to get gas prices back above replacement cost is to rapidly scale back development drilling.

Chesapeake Energy (NYSE: CHK) has generally taken charge on this front in the past, and this week, the firm once more proclaimed a production pullback. As the top independent producer in the U.S., not to mention the most active driller, these are more than mere token moves. By doubling its curtailment to 400 million cubic feet per day, Chesapeake is cutting back well over 10% of its total operated capacity.

Chesapeake took an interesting step in its press release on Thursday. While other operators like St. Mary Land & Exploration (NYSE: SM) have made the case for maximizing present value by deferring production, Chesapeake actually provided some charts and calculations. In the Barnett shale, for example, the firm estimates that a two-month-long full curtailment would create $7.7 million in incremental value on a pre-tax basis, yielding a 29% rate of return.

Everyone's making adjustments to the new reality, either because, unlike Petrohawk (NYSE: HK), they understand present value, or, like PetroQuest (NYSE: PQ), their credit line is tapped out, and they have no choice but to pull back. Just as night follows day, today's decisions will rescue tomorrow's rates of return for the E&Ps. It's just not quite clear when tomorrow will come.