Tuesday, July 13, 2010

EIA Report Shows Onshore Natural Gas Increase

The federal government’s Energy Information Administration (“EIA”) reported a larger-than-expected increase in natural gas supplies, reflecting an increasing onshore output. This was partially offset by soaring temperatures in the northeastern U.S. that provided a spurt of demand in the electric power sector.

Stockpiles held in underground storage in the lower 48 states rose by 78 billion cubic feet ("Bcf") for the week ended July 2, 2010. The latest build compares with last year’s net injection of 74 Bcf and the 5-year (2005-2009) average of 80 Bcf for the reported week.

The current storage level, at 2.76 trillion cubic feet ("Tcf)", is down 23 Bcf (0.8%) from last year’s level but remains 285 Bcf (11.5%) above the five-year average. Natural gas supplies have exceeded the 5-year average for this time of year in each of the past 14 weeks (since March 26, 2010) and are not far from last year's record highs at that time.

Though the ongoing surge in the commodity’s demand has erased a hefty surplus over last year’s inventory level, following a high of 101 Bcf for the week ending April 23, the specter of a continued glut in domestic gas supplies still exists, with storage levels remaining 12% above their five-year average.

Further pressurizing the commodity is the rapid rise in the number of drilling rigs working in the U.S. (the natural gas rig count has climbed 45% from a seven-year low reached last July) that signals a supply glut later this year in the face of sluggish industrial activity.

More importantly, production from dense rock formations (shale) remains robust. In fact, the share of shale gas in the country’s natural gas production has shot up from zero to 8% in the last decade. This has created a massive oversupply, compelling natural gas prices to slash from$13 per million Btu ("MMBtu") four years ago to just around $4.4 per MMBtu today (referring to Henry Hub spot prices). As there are more technological breakthroughs, shale gas has become viable in some cases at just $3 per MMBtu.

Recent forays by Reliance Industries Ltd. and BG Group into southern U.S. shale assets further point to the growth potential in this space. India’s largest publicly traded company, Reliance Industries signed a $1.3 billion agreement to acquire 118,000 acres in the Eagle Ford shale field owned by Pioneer Natural Resources (PXD - Analyst Report). On the other hand, U.K’s BG Group, through a joint venture with EXCO Resources (XCO - Snapshot Report), paid Houston-basedSouthwestern Energy Co. (SWN - Analyst Report) $355.8 million for properties in the Haynesville and Bossier shales.

There are concerns among traders that the market will be oversupplied in the short to medium term, with rig counts going up and industrial demand still struggling due to the weak economy. These factors translate into limited upside for natural gas-weighted companies and related support plays.

The gap between supply and demand is expected to reverse in the coming months as natural gas producers bet on the improving U.S. economy, the forecast of an active hurricane season and continuation of the summer heat wave.

Until then, we maintain our cautious stance on natural gas-focused E&P players such as EOG Resources (EOG - Analyst Report), Anadarko Petroleum Corp. (APC - Analyst Report), Chesapeake Energy (CHK -Analyst Report), EnCana Corp. (ECA - Analyst Report) and Devon Energy Corp. (DVN - Analyst Report).

All the above-mentioned companies currently have Zacks #3 Ranks (Hold) rating, meaning that these stocks are expected to perform relatively at par with the overall market during the next 1-3 months. Therefore, investors should maintain their current positions in the stocks over this timeframe.

Additionally, we remain skeptical on land drillers such as Nabors Industries (NBR - Analyst Report) and Helmerich & Payne (HP -Analyst Report), as well as natural gas-centric service providers such asHalliburton Company (HAL - Analyst Report) – all with Zacks #3 Ranks. Although we expect the land rig count to continue with its steady rise during 2010 (currently at 1,539 rigs, up 77% year over year), the large amount of excess capacity in the sector will weigh on day rates and margins well into the year.

Within the oilfield services group, we are positive on onshore contract driller Patterson-UTI Energy (PTEN - Analyst Report). The Zacks #2 Rank (Buy) rating on the company reflects Patterson’s premium newbuild fleet and stellar financial health (free cash flow positive and a debt-free balance sheet). Investors should also be impressed with Patterson-UTI’s recent acquisition of certain assets of onshore well service rig provider Key Energy Services (KEG - Snapshot Report) for $238 million. Apart from significantly expanding its shale drilling ability, Patterson-UTI also stands to benefit by coming out of their historical stronghold in the Appalachian Basin into the pressure pumping markets in the Barnett, Eagle Ford and Permian Basin.

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