Natural gas price hedges have played a big part in sustaining the onshore rig count to date, but that may not be the case in 2011, Barclays Capital analysts said this week. What may be key, they said, are 2011 forward prices.

"Hedges have been a key factor in the rising rig count this year, despite cash and prompt month prices that have stayed muted, even with a cold winter followed by a hot summer," wrote Barclays' Jim Crandell, Biliana Pehlivanova and Michael Zenker in a note to clients. "Without hedges, we expect the rig count to be much lower."

There are, of course, other "nonspot" price factors driving the rig count: held-by-production leases and joint ventures with drilling carry costs, as well as the growing move to liquids-targeted drilling in gas-rich areas.

However, producers "prefer to have their hedges in place right about the same time that students return to school," said the trio. Producers have about one-third of their 2011 hedging programs completed, they estimated. A "$5.50/MMBtu level appears to be the threshold that would trigger producers to top off their programs. But time is running short."

If "prompt-year prices do not rally, we expect producers to likely enter 2011 with less production hedged, prompting a cut in 2011 drilling."

Proof in point: at the end of 2Q2010 producers were "well hedged" for 2010 but less hedged for the coming year than at the same point for the prompt month in 2009 and 2008.

"Prices for 2011 have undoubtedly left producers underwhelmed," said the Barclays team. "Whereas calendar 2011 prices now sit at $5.02, prompt-year prices at this time last year were $5.96, and $9.18 at this point in 2008. This is reflective of not only the general drop in prices, but in the fading of the steep contango that not long ago typified the gas market."

As gas prices have fallen, producers have been able to lower costs in some plays with improved drilling and completion technology. For some producers, noted the analysts, this has helped preserve margins. "But pressing the other way has been rising service industry costs. Producers have noted especially the increase in well stimulation and completion costs. Thus, in a broad sense, technology is in a race against higher service industry costs and falling gas prices."

Barclays analysts are forecasting prompt month prices to "sag" through injection season, which would contain a positive swing in the forward curve. However, other factors could "delink" prompt year prices from short-term fundamental drivers. For instance, a "stout hurricane could boost 2011 prices temporarily above the $5.50 threshold."

Companies will hedge 2011 production through this year and into the next. However, most producers like to wrap up the bulk of their hedging before the coming year, said the analysts. "After all, service industry contracts have to be negotiated and signed, permits obtained and other operational factors considered. Drilling cannot be stopped or started on a dime."

The clock is ticking, noted the Barclays team. "Any good forward price opportunity should trigger a hearty 'back to school sale.'"

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