Anadarko Petroleum Corporation (APC), Chesapeake Energy Corporation (CHK): When Will Energy Companies Start Drilling for Natural Gas Again?

Page 1 of 2

Over the past couple of years, one of the most obvious trends in the energy exploration and production business has been the shift away from drilling for natural gas and toward drilling for oil and, to a lesser degree, gas liquids.

It all boils down to price. With natural gas prices at under $4 per MMBtu, most energy companies simply had no financial incentive to produce the out-of-favor commodity. And when prices dipped below $2 per MMBtu last spring, virtually every energy producer that was still drilling for natural gas was taking sizable losses.

But things are finally looking up. Natural gas prices have seen a general upward trend since bottoming out in April last year, as many analysts argued they would. Since the middle of February, prices are up by nearly 25%.

So why aren’t energy companies rushing into gassier plays?

Is gas too cheap to produce?
The short answer is that oil production is still much more profitable than natural gas production. Despite the recent surge in gas prices and decline in oil prices, oil remains about six times more expensive than natural gas on an energy equivalent basis.

Hence, energy companies with the flexibility of migrating their rigs toward oilier plays will continue to do so as long as oil production remains more profitable. This raises the next crucial question — at what price level is it profitable for energy companies to produce natural gas?

That’s tough to say because the economics of various gas formations differ considerably, depending on such factors as the play’s geology, subsurface pressures, and the level of pipeline and gathering infrastructure.

For instance, some producers drilling in the Marcellus shale of Pennsylvania — a play widely recognized as the most economical in the country — can reportedly turn a profit with prices just north of $3 per MMBtu. But other gas plays aren’t economical unless prices are twice that level or more.

Anadarko Petroleum Corporation (NYSE:APC)‘s drilling program in the Marcellus is instructive. For the company’s Marcellus operations to be economically viable — i.e., deliver a 20% pre-tax rate of return on drilling — gas prices need to be at least $3.25 per MMBtu.

But just because a drilling program is economically viable doesn’t mean the company will immediately begin to allocate capital toward it. For that to happen, it has to offer a rate of return that’s attractive relative to the company’s other opportunities. In Anadarko Petroleum Corporation (NYSE:APC)’s case, natural gas prices would have to climb above roughly $4.25 per MMBtu for the Marcellus to start diverting investment away from the company’s other projects.

That leads to the final crucial consideration to help answer the question posed at the beginning — breakeven prices for different natural gas producers.

Page 1 of 2