Drilling To Hold Acreage May Hurt Big Picture

By Eric Fox | May 11, 2010 AAA

Many exploration and production companies are continuing to develop natural gas properties in order to hold onto leases that are coming up for expiration. This may be aggravating the weak fundamental outlook for the commodity, as activity should be dropping to balance the market.

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Supply and Demand
The way a normal cyclical industry works is that when there is oversupply and weak pricing of a product or commodity, the industry cuts back on production, which eventually leads to a balanced market and firmer pricing.

There are frequently forces that interfere with that normal corrective mechanism, and this can be seen in an examination of the practices of the exploration and production industry. Despite a shift in capital from developing natural gas properties to oil and liquids development, the industry continues to drill too many wells in natural gas basins in the U.S., possibly worsening a precarious fundamental situation in that sector.

Many exploration and production companies are drilling because they need to convert leases from term to held by production. When a company leases mineral rights from an owner, that lease will typically have a term of three to five years. The operator must start developing that lease within a certain time or the rights will revert back to the owner. An exploration and production can drill a single well and hold a larger section or unit and then come back later and do infill drilling.

Companies Holding By Production
Talisman Energy (NYSE:TLM) just initiated a position in the Eagle Ford Shale, and said during the quarterly call that it would spend from $30-50 million per year to hold the acreage by production. Although this acreage is in the liquids portion of the play, wells here will still produce some natural gas and add to the oversupply situation.

Forest Oil (NYSE:FST) has 28,000 net acres under lease that is prospective for the Haynesville and Bossier Shale, and is drilling in the play only to hold leases. John Ridens, the COO of Forest Oil said, "The majority of our drilling this year is to hold leases, and we will have almost all of our land held in this play by the end of 2010."

Cimarex Energy (NYSE:XEC) has 100,000 acres in the Cana Woodford Shale, and said during a recent conference call that it has a "lease expiration issue we're having to manage." The company said that about 50% of its core acreage is held by production, and that it is drilling "preferentially to hold acreage" in 2010.

Devon Energy (NYSE:DVN) also said during its quarterly conference call that its acreage in San Augustine County that is prospective for the Haynesville Shale is term acreage, and is drilling to "really get a good handle on what the potential is of our term acreage."

The Bottom Line
Drilling to hold leased acreage may be the best thing for an individual company as it seeks to protect what may be a considerable investment in time and money in a coveted basin. The collective effects of such a strategy, however, may prevent market forces from correcting a cycle. (Learn about factors that affect oil prices in our article, What Determines Oil Prices?)

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