Rig counts in the U.S. are back down to July, 2005 levels as crude oil prices have dropped back to the $40 range.

Baker Hughes (BHI: chart, web, Y!) has issued the rotary rig counts as a service to the petroleum industry since 1944, when Hughes Tool Company (of Howard Hughes fame) began weekly counts of US and Canadian drilling activity.

The rig count acts as a barometer for the drilling industry and its suppliers.  In effect, the more drilling rigs out making holes in the ground, the more is being spent on exploration, leaving one to believe that the industry believe oil prices justify drilling for more production.

As of last Friday (rig counts are updated at noon on the last day of the work week) the US rig count was down by 73 rigs with a total of 1,399 rotary rigs actively drilling.  Of those, 283 are being used in drilling exclusively for crude oil.

That compares to data from back in July, 2005, when 1,404 rigs were working, but at that time the count was steadily increasing.

This data indicates that the oil and gas industry doesn’t see crude oil prices rising substantially any time soon, so as not to increase capital expenditures to increase production.  In fact, most analysts are expecting a production cut by OPEC at the next meeting in March.

As for natural gas…

Baker Hughes also publishes the number of rigs used in drilling for natural gas.  That number dropped this week by 46 to 1,104 rigs.

Directional drilling has declined also, which isn’t surprising.  The cost of drilling a horizontal well is far greater than drilling a conventional straight bore well.  In this environment, there’s no point in spending top dollar only to have to shut in production due to poor economics.

Corner Office Comments

I believe crude oil will continue to trade in a $40 to $50 range for the next several months, with an occasional but short lived dip below $40.

OPEC will most certainly cut production in March, but to what effect those cuts will have on market prices for crude is uncertain.  The market has not reacted in like kind in the past, and I suspect it won’t care much about OPEC cuts this go ’round either.

Oil & Gas Baker Hughes, BHI, oil and gas, rig count

Have you noticed prices at the pump lately? In my area, gas went from $1.39 per gallon to $1.79, even while crude oil prices are floundering below $40 per barrel.

There seems to be a significant divergence of crude oil prices as compared to gasoline, and it’s indicative of a shift between demand for crude oil and production output of refined products.

Refiners margins have been down recently due to the drop in crude oil. During the fourth quarter of last year, the price of a barrel of crude oil was actually more expensive than a barrel of unleaded gasoline (remember there are 42 gallons in a barrel). That meant that the refineries were paying more for the raw material than they were selling their product for. Hence, the drop in refiner stocks, such as Valero (VLO: chart, web, Y!) and Tesoro (TSO: chart, web, Y!).

Now that oil prices have started to stabilize around $40 per barrel, and refiners have taken delivery of their crude purchased for much higher prices, they’re starting to increase their margins by cutting production.

In the first week of January, refined gasoline totaled 9.1 million barrels per day.  By the end of the second week of January, total production was 8.8 million barrels per day, a 300,000 barrel per day drop in refined products.

Demand has been dropping for the last three weeks, and demand on January 9th hit 8.75 million barrels per day.  So production is just keeping up with demand, and no more.

Gas prices typically lag crude prices by a month; two depending on how futures contracts play out.

Corner Office Commentary

If oil prices continue to trade between 35$ and $40 per barrel for the next two months, I would expect gasoline prices to start to turn the corner and head down at the beginning of February.

The change in refined product output should run its course by the end of this month, so long as more output cuts are foregone.  Even then, once the refiners build margin back into their books, we should see gas prices stabilize.

Oil & Gas gas prices, gasoline, oil and gas, oil prices, refinery, Tesoro, TSO, Valero, VLO

Sometimes you have to go with your gut, and when your gut ends up being right, you get this warm and fuzzy feeling that you may actually know a thing or two.

Frequent readers of The Corner Office Blog know that I’ve been bearish of Chesapeake Energy (CHK: chart, web, Y!) due to their huge amount of debt (and the pilfering of shareholders to pay off that debt by diluting the stock) when commodity prices were at record highs.

I’ve owned CHK before and have made money off the stock, but when credit started tightening over the last year to 18 months, I knew CHK would end up with a target on its back just due to the debt alone.

Well, it seems the debt has come back to haunt Chesapeake, along with an in-house trading philosophy that ended up costing the company $1.6 billion on paper, and forced CEO Aubrey McClendon to sell all of his own companies shares involuntarily.

Here’s how it all went down.

Chesapeake was making money hand over fist when commodity prices were high, just like any other player in the field.  Then, their trading operations made the gamble that the run on oil and gas wouldn’t continue.  So the company bought options and other financial vehicles to lock in the current rates (around $120/bbl for oil at the time) to protect from what they saw as an expensive downside risk (also known as hedging).

So what happened?  Oil continued to rise to a high of just over $145/bbl in July of this year.  That’s actually a good thing for Chesapeake, right?  Not necessarily.  Since Chesapeake hedged their oil at $120, they were only getting paid $120 for every barrel they pumped, not $145 that was the current market price.  Again, they’re still making boo-coo bucks at $120 oil, but they could have been making more.

The fact that they could have been making more shows up as a loss on the balance sheet.  All in all, Chesapeake could have made as much as $1.6 billion more if they had not hedged their oil and gas at lower prices.  So this goes as a loss on the books for the second quarter.

What effect does the debt have?

Creditors typically want to see that their their loans are safe, and as such they write in certain conditions that if met, they reserve the right to call the note.  Sort of like having a margin call if you can’t maintain the margin requirements. Read more…

Energy, Investing, Oil & Gas CHK, hedging, margin, oil and gas