Key Gas Indicators Suggest Another Midstream Push

Volatility is not just about the direction of prices, or the frequency of market ups or downs. It also manifests itself in ways you simply won't see on page 1 of the Wall Street Journal.

Take, for example, an intriguing situation in today's natural gas sector…

Every week, Baker Hughes Inc. (NYSE: BHI) releases a rig count, tallying the total number of rigs used in the extraction of both oil and natural gas here in the United States. And after analyzing the numbers for the week ending Friday, December 9, what I found was surprising. The company's weekly rig count indicated a decline of drilling rigs for gas wells.

However, the same report indicated a rise in rigs being used in oil fields. The gas-rig-usage figure declined by 36 for the week and stands 128 below the count for this week in 2010. In contrast, oil rigs increased 29 for the week and is up approximately 50% (1,132 versus 763) over the same week last year.

Now such a decline in gas well drilling, coming off similar weakening numbers over the past month, seems to indicate that the market has concerns over too much gas supply coming on line too quickly.

With prices in gas futures contracts deflating – despite colder winter months approaching – the balance of supplies in the system becomes an important consideration.

This market sentiment, of course, is a result of the rapid acceleration in unconventional gas drilling, especially in shale basins such as the Marcellus, Fayetteville, and Barnett. And the continued emphasis on shale continues to be observed in the rig figures.

Last week, horizontal rig usage (used for both gas and oil shale wells, as well as some conventional applications) declined by five. However, the figure was still up by more than 19% — 185 more rigs in use – compared to the same period a year ago.

Turn That Rig (Back) On

The transferred emphasis to oil (and the recently higher market prices) has prompted an increasing reliance on recommissioning already depleted wells back into service. The number of workover rigs in use (meaning those employed to upgrade existing wells back into service) continues to climb.

This would appear to indicate a decreasing reliance on new gas drillings, as well as a return to crude oil.

Well, that is not as simple a conclusion as it would seem.

For one thing, the number of gas wells drilled over the last 18 months has been nothing short of staggering. The volume already flowing into the network has been increasing available gas for each of the last two years.

In fact, there is so much extractable shale gas that the overall amount available to the market could increase by 25% per year over the next few years.

And that would impact prices.

The average shale gas well is providing most of its volume in the first 12 to 24 months. Therefore, as demand increases (and it is, especially in the usage of gas to power electricity generation), the number of operating wells will have to rise in the near future.

So, the decline in drilling appears to be a temporary thing.

However, something else is happening that has improved the profitability expectations for a specific segment of the gas sector…

A Boost to Midstream Operations

Again, the "midstream" is where services exist between the fields where the gas is produced (upstream) and the primary processing, treatment, distribution and sales (downstream).

And as demand (especially industrial) rises, a shortfall is developing rather quickly.

The need in petrochemicals for natural gas liquids (NGLs), especially ethane, will outstrip supply in 2012, according to a report issued Friday by Fitch.

The report indicates that this shortfall will moderate as midstream operators spend considerable capital on projects to make additional volume of NGLs available.

Prior to this, according to Fitch, the money was primarily being used for mergers and acquisitions.

"The recent shift toward more fixed-fee arrangements with producers will continue, and a focus on growth projects, such as NGL pipelines, backed by long-term, fixed-fee type contracts, to be moderately beneficial to credit quality," the report says.

Fitch also noted what we have already observed.

There will be a reduction in new gas volume coming on line, although the overall flow available for gathering production from multiple fields (one of the primary services provided by midstreams) will remain flat to moderately higher next year.

Fitch notes that there is no question the production focus is transferring quickly from conventional to shale sourcing.

"Fitch expects continued stable revenues from gathering and treatment facilities, which are generally supported by the prevalence of fee-based arrangements with producers," the report concludes.

More to the point, this report mirrors information coming from several sources, all indicating that midstream providers are better able to insulate operations from the sole impact of commodity prices.

The industry does not expect a return to the high swings in gas prices witnessed in 2008 and 2009, although the price will be rising in a more sustainable manner.

Meanwhile, market demand for NGLs should shift investors' attention to companies that process, treat, and transport constituent elements or byproducts in the gas flow.

This will provide a very positive benefit for midstream suppliers, especially those that focus on natural gas liquids.

As a result, we can expect to continue seeing both capital appreciations in share value and annualized dividend levels well above the market average.

Always nice to get two pops for the same investment.

Disclosure: None

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