We think there's enormous opportunity to be had in natural gas in
the coming years, but it's important to know the ins and outs
before investing. In this is two-part series, StreetAuthority's
David Sterman will discuss the current situation with natural gas,
when he thinks it will be "time to buy," and three of his favorite
ways toprofit . The following article is Part 1 of our
Place the number 725 in your mind. In a few moments, I'll explain
why it's the figure that could finally spell the end of the
natural gas industry's troubles. The good news: 725 will soon
approach, and that's when it will be time to buy into this sector.
By now, you've read countless articles about the rise and fall of
the natural gas industry. A half decade ago, the industry was giddy
with delight because a newly-refined drilling technique (hydraulic
fracturing, known as "fracking") turned seemingly dormant energy
fields into absolute gushers. As company after company announced
promising drilling results -- and the ensuing robust spending plans
-- few realized that the basic laws of supply and demand would soon
And those laws are unbreakable.
In the middle of the last decade, gas wells weren't all that
productive, and the industry put an increasing number of wells in
service just to find enough gas to meet our nation's needs. In
fact, the natural-gas rig count, as tracked by energy firm
Baker Hughes (NYSE:
, spiked from 966 at the end of 2003 to around 1,450 by the end of
By the middle of 2008, the price of natural gas spiked to $13 per
MCF (thousand cubic feet) as supply only slowly started to catch up
to demand. Yet by end of that year, gas would be back down to $5
MCF. Many thought that was due to the slow U.S.
, but few realized that the industry was creating a nightmare
scenario as newly-productive gas rigs threatened to create a glut
of natural gas that simply couldn't be absorbed by demand.
At the time, the industry simply assumed that older,
less-productive wells would peter out and supply would eventually
drop. Indeed, the number of wells in service dropped by a whopping
43% in 2009 to just 759 -- the lowest figure in more than a decade.
Please, make it stop
Even with fewer rigs pumping out gas, few understood the depth of
the problem. Assumptions that industry output would naturally
decline led many gas drillers to conclude that it was time to put
more rigs back in service to help maintain output. So the rig count
rose 21% in 2010 to 919. As supply of gas eventually overwhelmed
demand, prices utterly collapsed, recently falling below $3 per
The key factor that everyone underestimated: fracked wells are so
much more productive than traditional wells, and they last a lot
longer than most expected, so a simple correlation between rigs in
service and industry output no longer held. Consider this data
point from Pritchard Capital Partners: The number of rigs tapping
into the Barnett Shale (in Texas) fell from 88 in October 2010 to
56 in October 2011. Yet output in the Barnett Shale actually rose
from 5.4 billion cubic feet (
) per day to 5.7 BCF. This means each well remaining in service was
40% more productive than each well taken off-line.
Yet the long nightmare for this industry should soon end, for a
very prosaic reason. Recall the number 725 I mentioned at the start
of this article. That's the rig count needed to bring down
production to where supply falls to demand levels. It's a far cry
from 992, the number of gas rigs that were in service back in
the summer of 2010. Now look where that figure stands.
As of Jan. 27, 2012, the weekly natural-gas rig count stood at just
777. And it's about to drop even more. Industry leader
Chesapeake Energy (NYSE:
announced it is taking 23 rigs out of service. These are healthy,
productive rigs. At first blush, this would seem to be a foolhardy
move, but it's actually simple
. Chesapeake is counting on many of its peers to also bite the
bullet. Common sense dictates that a reduction in gas output would
fuel a spike in prices, putting all players ahead in terms of
EXCO Resources (NYSE:
, have also recently announced plans to take drilling rigs offline.
Let's assume that Chesapeake's other peers never took the Game
Theory course in college, and keep pumping away. Output of gas will
still fall, as these players are at least wise enough to stop
putting new wells into service. Simply put, it's almost impossible
to make profits when
prices fall below $3.
As a result, the existing wells will slowly see falling output as
each quarter passes. Despite the unexpected robust initial output
noted in places like the Barnett Shale example earlier, the
depletion of wells is one of the immutable laws of physics when it
comes to energy drilling.
The fact that natural gas prices remain in a deep funk, despite rig
count starting to come down quickly, is simply evidence of a
. The current crop of rigs is remarkably productive, so output
isn't falling nearly as fast.
But it's only a matter of time.
The investment community cares only about one thing: Natural gas
stocks will be a bargain only when industry output falls below
demand and the stunning amount of natural gas in storage starts to
be worked off. Analysts at JP Morgan think the natural-gas rig
count will need to fall closer to that 725 mark (from a
current 777) for supply to drop far off. We'll may even have to do
even better than that, thanks to a very mild winter that has
reduced demand for gas.
Consider this graphic from the U.S. Energy Information
The red line tells you that we're at the high end historical range
in terms of seasonal storage figures.
Time to buy?
There are two schools of thought about when investors will pile in
to natural gas stocks. Most
analysts will upgrade their ratings when the industry storage
levels start to come down and natural gas prices move handily above
the $3 pre MCF mark and toward the $4 mark.
But another school of thought suggests it's always best to buy into
an industry a few quarters before the dynamics start to improve. In
effect, if you wait for a tangible turn, you will have missed it.
I'm of another mind. Call it the "third school of thought." Why not
split the difference?
• Watch the rig count and trace its trajectory to that
all-important 725 rig count.
• See whether competitors respond to Chesapeake's bold move to cut
• Monitor Washington's discussions about potential legislation in
support of natural gas-powered vehicles.
• Track what the IEA has to say about gas in storage. If gas in
storage begins to drop at a more robust pace, then natural gas
traders will start to take note.
Action to Take -->
You can't wait for these sign posts to shift from red to green. By
then, it will be too late. Instead, you need to see them start to
For example, I'd be a buyer of naturalgas stocks when the rig count
is at 725, regardless of what spot prices indicate. Or I'd be a
buyer if storage levels sharply dropped, even if the underlying
price of natural gas failed to respond initially.
In part two of this piece, I will look at three natural gas
investment ideas that represent a distinct set of risks and
If you haven't heard about this unique opportunity, then I want to
tell you about it now. StreetAuthority has staked me with $100,000
of real money to invest in my absolute best ideas. For a limited
time, you'll be able to follow along with me completely free.
Go here to learn more
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC owns
shares of CHK in one or more if its "real money" portfolios.
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