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Slight Uptick in Gas Drilling Raises Concerns

An oversupply of domestic natural gas this year is "nearly a foregone conclusion," but the uptick in gas drilling rigs earlier this month may signal a new battle on whether U.S. producers can reset the supply/demand balance in 2010, Barclays Capital analysts said in a report Tuesday.

A slight uptick in gas-directed drilling for the week ending June 19 at a single data point may not be an indication of a shift to more drilling but it "highlights the upside risk to supply and therefore downside risk to prices if producers regrow the rig count," wrote analysts Jim Crandell, Biliana Pehlivanova and Michael Zenker.

No other driver -- the recession, liquefied natural gas or hurricane risk -- is likely to affect gas balances as much as shifting domestic supply, the Barclays team wrote. And while there is an abundance of rigs and drilling targets available to keep the market oversupplied, "it is not a matter of whether producers regrow production above demand levels, but when."

Crandell and his colleagues likened the prolific supply results from shale drilling to a new battlefield weapon.

"One might say that price recovery in the natural gas market needs a little 'gun control.' The new state of affairs showed much more producer restraint, but then along came last week's accidental discharge," they noted.

The Baker Hughes rig count for the week ending June 26 reported 687 natural gas rigs in North America, five fewer than a week earlier. The Baker Hughes count for the week ending June 19 had reported the first uptick in gas drilling since last November, with seven rigs added, to 692 rigs.

The higher domestic rig count could be an aberration, said the analysts. However, the uptick came following:

"Producers have a strong incentive to boost company-level production as production growth is an important metric in their share price multiple," noted the analysts. "Producers have almost certainly taken advantage of the recent move higher in prices further out along the curve by hedging more of their production. This gives them more ammunition to justify putting rigs back to work."

If the recent increase to the rig count is the start of a drilling recovery, the Barclays team said its view on gas prices in 2010 "would shift in a more bearish direction...While it is still too early to judge a shift in sentiment, we note that a steady trickle of news points to more drilling and supply than our base case. Like it or not, how producers use their guns will decide which path the market follows."

While the market "is anxious for signs of collapsing volumes to offset tepid industrial/weather demand," energy analysts at Jefferies & Co. Inc. said last Wednesday they "are not counting on gas supply to rebalance the markets."

Jefferies previously forecast a modest 5% decline in gas production this year.

"Anything more would be welcome, but we are more likely to see evidence of collapsing production in the weekly storage numbers before it is validated" by Energy Information Administration (EIA) data or anecdotal evidence, the analysts said. As of June 19, working gas storage levels were 631 Bcf higher than last year at this time and 482 Bcf above the five-year average.

Most companies are hedging what they can in 2010-11 with what appears to be a $5-6/Mcf floor, according to the Jefferies analysts.

"All said, the industry can only hedge a small fraction of their [net asset value] or enterprise value. Also the industry remains leveraged. So spending plans must be balanced against the need to reduce bank debt...joint ventures are another preferred option. Raising equity is a last resort. This is a dramatic reversal of prior years where bank debt allowed the industry to spend well above cash flows."

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