Decline in Drilling and Demand Recovery: How Will They Impact Prices?

March 2009

• There is typically a lag in drilling activity relative to movements in natural gas prices. When natural gas prices began to drop suddenly in July 2008, drilling activity did not begin to decline until two months later.
• Mid-September 2008, there were 1,606 rigs drilling for natural gas. As of mid-March 2009, there were 884 in operation.
• Current levels of drilling activity may not be sufficient to accommodate the expected increase in demand as the economy recovers resulting in a definite upward pressure on prices.

Like several other indicators in the current economic downturn, rig drilling activity has been declining since September 2008. As of September 12, 2008, there were 1,606 natural gas rigs operating in the US. As of March 13, 2009, there were 884 in operation. Despite the drastic cut in supply, prices have continued to fall further as the recession has stifled non-residential demand.

As the first chart below shows, there is typically a lag in drilling activity relative to movements in price. Following the spike in prices in the winter of 2000/01, drilling activity continued to grow until the summer of 2001. By then prices were already falling and the belated reversal in drilling activity ensured that inventory would remain at the then 5-year maximum until the winter of 2002/03.

As the US economy expanded between 2003 and 2008, drilling activity and prices also rose. Nevertheless, drilling activity remained at a relatively high level while prices fluctuated between $4.50 and $8/MMBtu in this period. It is interesting to note that activity was beginning to fall in the second half of 2007 in response to prices having remained in the $4.50-$8 range during the previous 18 months.

As prices started to rise in the first half of 2008, drilling activity began to follow suit. When natural gas prices began to drop suddenly in July 2008, drilling activity did not begin to decline until two months later. While the reaction of rig operators to price appears to have occurred with less of a lag compared to previous years, operational considerations made it impossible for rig operators to reverse plans in midstream as quickly as extreme price movements would suggest.

What the first chart below also highlights is that large fluctuations in natural gas prices can occur at any time. For example, there was a jump in prices in January 2003 just as the US economy was recovering from the recession brought on by the end of the dot-com boom. This price spike was caused by unusually cold weather occurring when gas storage inventories were approaching the 5-year minimum.

In 2005, the disruptions caused by hurricanes are well-documented and prices rose even though inventory levels were approaching the 5-year maximum. Lastly, the spike of 2008 occurred even though the US had already entered the current recession and inventory levels were near the 5-year average. It is also interesting that drilling activity had not been falling in the run-up to these upward shocks.

With the most recent steep decline in rig drilling activity and prices, it seems reasonable to expect that a price spike is in the offing. The inherent lag in changes in drilling activity relative to demand will mean that current levels of drilling activity may not be sufficient to accommodate increased demand brought on by extreme weather. Demand beyond that attributable to extreme weather should also rise as the economy recovers.

Indeed current forward markets are in contango, with prices of monthly contracts for successive years being higher than those for 2009. This means the market is behaving with the view that prices will be higher in the future as demand recovers. This anticipated recovery in demand would put definite upward pressure on prices if rig operators cannot respond quickly enough to not only the recovery but also any additional demand attributable to harsh weather conditions.

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