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Raymond James Estimates 3Q Gas Output Down 5.4% -- Adjusted for Hurricanes

Despite a 30% increase in domestic natural gas drilling over the past two years, the decline in U.S. gas output continues, and much like the 1970s, when oil output continued to fall, gas production may be nearing "if not at" a similar crossroads, Raymond James analysts said last week. Adjusting for the hurricanes, estimated 3Q2005 domestic gas output fell 5.4% from 3Q2004 and 6% sequentially from 2Q2005. Those predictions far exceed predictions of other industry experts.

The energy industry is now at "virtually 100% utilization" of onshore natural gas rigs, coupled with gains in drilling efficiencies in the past two years, according to Raymond James' Wayne Andrews, J. Marshall Adkins and Pavel Molchanov. However, "going forward, constraints on rig availability are likely to become more pronounced, and gains in efficiencies should slow. Meanwhile, the quality of prospects that are being drilled is diminishing, and organic decline rates for the industry continue to rise. This means that the U.S. gas supply picture remains quite constrained."

To ensure the analysis of measured quarterly gas output excluding the hurricane impacts in the quarter, the Raymond James analysts "added back" the hurricane-related shut-ins using the Minerals Management Service (MMS) figure of 196.5 Bcf of offshore production deferred between Aug. 26-Sept. 30, or an average of 2.1 Bcf/d across the entire quarter. In addition, 55 Bcf (0.6 Bcf/d) of coastal Louisiana production was deferred during the same time period.

Because it was not possible to determine what percentage of the deferrals were attributed to companies in the Raymond James' survey, analysts estimated the figure at no less than 60%, and used 65% to "add back" 1.8 Bcf/d to the survey's reported 3Q2005 output. Also, given that Hurricane Ivan impacted 3Q2004, an analogous adjustment was made for that quarter's production, which was 57.9 Bcf or 0.6 Bcf/d, according to the MMS. "Applying the 65% factor, the 3Q2004 adjustment is 0.4 Bcf/d. After these two adjustments, which we readily admit are imprecise, our analysis yields an underlying (excluding hurricanes) year-over-year decline rate of 0.3%, somewhat lower than 2Q2005's 1.2%."

The survey found the majors and gas utilities showing the largest declines in gas production, down 11.4% (on a reported basis, i.e., including the impact of hurricanes) versus last year. "This is important since: (1) the majors and utilities represent a large proportion of U.S. gas supply (roughly 20%) and (2) drilling activity in this group has been relatively flat since the start of 2003. This indicates that further production declines lie ahead for this group."

The survey also showed "an even more astonishing reality: the independents are driving drilling activity increases, with only modest production response from the group to show for it. Specifically, the public independents have been responsible for putting an additional 91 gas rigs to work (a 25% increase when the September 2005 number is compared to the September 2004 number), and yet their corresponding production in 3Q2005 actually declined 1.0% year-over-year and 3.3% on a sequential basis (compared to the 2Q2005 sequential growth of 1.1%). "

Only a few of the independents in the survey kept the overall group from posting "much larger overall declines," said analysts. "Without the large organic increases in production from Chesapeake Energy, EnCana Corp., EOG Resources and Ultra Petroleum, the E&P group's year-over-year decline would not have been 1.0%, but 4.3%!"

However, the Raymond James survey only covered about 50% of total U.S. gas production -- the "other" 50% is by smaller, mostly privately held exploration and production companies.

"Given the vast number of these small players, it is impossible to get an accurate assessment of what their production is doing," analysts said. "Over the past 12 months, growth in gas rigs among companies outside our survey has lagged that of the independents included in the survey. Given this, plus the fact that drilling inventories among private companies tend to be smaller than that of larger public companies, we believe that their 3Q2005 production was essentially flat on a year-over-year basis, perhaps posting a marginal increase."

The 3Q2005 numbers included "plenty of volatility...with weather the most obvious cause." Excluding the hurricanes, "these results do provide further evidence that the decline rates underlying U.S. gas production are indeed moderating, as had also been the case in 1Q2005 and 2Q2005. Despite the moderating trend, however, we still think that production will continue to decline modestly for the foreseeable future."

Analysts noted the Energy Information Administration (EIA) is "recognizing" the moderating trends, "following multiple downward revisions, with its current data for full-year 2004 now showing a year-over-year production decline of 1.1% for the entire industry. This is much more believable than EIA data showing a production rise in 2004. Remember: Our surveys cover 50% of U.S. gas production. If this is in decline, expecting growth from the small, mostly privately held, producers outside our survey does not seem feasible."

The EIA reported earlier this month domestic dry gas production in 2005 is likely to decline by 4.2% due in large part to the major disruptions to infrastructure in the Gulf Mexico from the twin hurricanes. However, EIA expects domestic gas production to increase by 4.7% in 2006 (see NGI, Nov. 14).

Raymond James' bullish North American energy thesis continues to be centered on the "underlying problem" of falling U.S. gas output. Supply declines in 2006 should be less severe than in 2004 and the first half of 2005, but "we expect domestic gas production levels to continue trending down," with U.S. gas prices near the traditional 6:1 Btu parity with crude oil, and potentially higher, depending on the weather.

"While short-term gas prices and oil/gas price ratios should continue to be volatile, if oil prices remain near the $60/bbl level, this would imply fair value for gas at least around $10/Mcf. Our current gas forecast of $9.25 for 2006 is quite conservative by comparison."

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