Tuesday, March 24, 2009

Chesapeake’s Take on the Gas Market

In its most recent investor presentation, Chesapeake detailed its beliefs about the domestic natural gas market and how the supply and price issues will play out over the next several years. In a nutshell: because of the continued derease in drilling rigs deployed and the steep decline rates of gas wells, supply should drop in the next 1-2 years as production wanes without new drilling to support it, and price should rise accordingly. Below is an excerpt from the Company's presentation:

"* Higher production levels and lower demand will keep natural gas prices low in 2009

* However, the fix is already in, gas directed rig counts are now at the lowest level since early ’03 and headed lower, fast

* Industry first year depletion rate of ~25-30% will fix supply/demand in balance by YE’09, just as the economy likely begins to recover

* CHK sees U.S. natural gas market as oversupplied in 2009, but balanced thereafter
> CHK sees U.S. natural gas prices at Henry Hub averaging $4-6/mmcf in 2009 and $7-9 in 2010 and beyond
> Natural gas prices not likely to stay permanently low because of great success of the “Big-4” Shale plays (Barnett, Fayetteville, Haynesville and Marcellus). Instead, it will be the highest cost one-third of U.S. production that will set out-year natural gas prices, not the lowest cost one-third...

* Against unrelenting pessimism about U.S. natural gas prices in early 2009, there is emerging evidence that market forces are creating the conditions for a strong natural gas price recovery in 2010 and 2011

* What is that evidence? It’s plunging rig counts (40-50/week lately) and accelerating decline curves (the “dark side” of technology)

* What do we know today?
> First year U.S. decline rate is ~25-30%, i.e. ~15-18 bcf/day
> 2008 U.S. gas production YOY increase of ~7%, or ~4 bcf/day
> 2008 natural gas rig count averaged ~1,500 rigs – this overcame first year depletion of ~25% and generated growth of ~7%, for a combined ~32% addition rate
> If natural gas rig count went to zero, then all would agree this ~32% number would also become zero
> So, if natural gas rig count goes down by 50% in 2009, CHK believes industry will lose nearly 40% of this ~32% production capacity increase, through which ~7% growth disappears and ~7% production declines appear by 2010. So, YOY growth of ~4 bcf/day in 2008 will soon give way to a decrease of ~4 bcf/day, setting up a big price rebound in 2010 and 2011 if U.S. economy does not materially weaken from here."

Chesapeake strongly argues the point that new drilling is important to keep up the national supply. In a chart, below, they show that because of well decline rates nearly half the U.S. production comes from wells drilled within the past three years. With severe decreases in rig count, the lack of new production will shock supply within a year or two. Chesapeake estimates that the rig count decline will stop at 750, which is still considerably below where we are today (Baker Huges reported that the U.S. rig count as of last week was 1,085). This condition will significantly curtail supply and impact the overall price of natural gas. There are reputable analysts that expect the number of operating rigs to drop to 600, which would cause even greater shocks to the system. See Chesapeake's slides below.

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