Growth in U.S. Natural Gas Production Expected to Reverse

After remaining essentially flat for almost 9 years (1998-2006), natural gas production in the Lower 48 started trending up last year and really accelerated this year. Production increased around 5.5% in 2007 and remains on track to grow in excess of 9% in 2008.

What has been driving this growth spurt? And, given the economy's cloudy outlook and continued credit-market turmoil, can this production growth momentum be sustained going forward?

Favorable prices prompted increased natural gas drilling, with the total onshore rig count making a new all-time high this year. Also, technological improvements enabled the industry to economically develop resources that could not be cost effectively developed in the past. At the forefront of the technological improvement has been the widespread use of 'horizontal' drilling (as against the conventional vertical drilling) to develop the so-called unconventional resources. Horizontal drilling rigs now account for approximately 28% of the total rig count, up from the 1990's average of about 5% of the total. Texas has been at the forefront of the current growth spurt, accounting for roughly half of the total growth this year. The state now accounts for about one-third of all Lower 48 natural gas production. The bulk of Texas' growth resulted from the use of horizontal drilling of a long-known geological formation, the Barnett Shale, most of which is located beneath the city of Fort Worth.

A combination of low prices and restricted access to capital is expected to reverse the recent production-growth momentum. Exploration and production companies, the dominant natural gas producers in the U.S., were spending heavily on drilling activities in the last few years. Over the last 2 years, companies in our E&P coverage universe were spending, on average, about 25% in excess of their internal cash flows, with the capital markets making up the shortfall. With that avenue essentially closed, E&P companies are constrained to live within their means; by cutting back capital expenditure plans for 2009. The resultant fall off in drilling (the rig count could drop in excess of 30% from its peak) is expected to reverse the production-growth momentum of the last 2 years.

We believe that reduced natural gas production over the coming quarters will set the commodity up for a rise in prices late next year and into 2010. Our top E&P picks, XTO Energy ( ) , EOG Resources ( EOG - Analyst Report ) , EnCana ( ECA - Analyst Report ) , and Chesapeake Energy ( CHK - Analyst Report ) , are a play on this outlook.

Read the full analyst report on XTO

Read the full analyst report on EOG

Read the full analyst report on ECA

Read the full analyst report on CHK