Natural gas prices will remain depressed relative to crude oil through the summer, but as the gas storage surplus is worked off, Raymond James & Associates Inc. expects a gas price rebound to the traditional 6:1 oil-gas ratio heading into 2007.
"Today's gas story is much like the 1970s oil story, when oil production continued to stagnate despite greater and greater numbers of active drilling rigs," the firm wrote in its weekly energy industry brief. "Accordingly, we expect domestic gas production levels to remain relatively flat over the foreseeable future, with some quarters showing small declines and others showing limited growth."
Raymond James said that depending upon weather, gas prices might even bust out of the 6:1 ratio with crude. "While short-term gas prices and the oil-gas price ratio will continue to be volatile, if oil prices remain near the $70/bbl level, this would imply fair value for gas well above $10/Mcf."
While the Raymond James 1Q 2006 survey reveals a 2.8% year-over-year production decline, including the impact of hurricane-related shut-ins, this is deceiving. "It is important to 'add back' the hurricane-related shut-ins to calculate the underlying decline. According to the Minerals Management Service (MMS), 144 Bcf of offshore production was deferred in 1Q06, an average of 1.6 Bcf per day (down from 4.0 Bcf/d in 4Q05)."
Assuming that 65% of the deferred production is attributable to the large companies in its survey, Raymond James adds back 1 Bcf/d to its survey's reported 1Q06 production. "However, given that 1Q05 was affected by Hurricane Ivan, we must make an analogous adjustment to that quarter's reported production, which, according to the MMS, is 22 Bcf (0.24 Bcf/d). Applying the 65% factor, the 1Q05 adjustment is 0.16 Bcf/d."
After these two imprecise adjustments, the firm finds a modest year-over-year growth rate of 0.5% in 1Q 2006 compared to growth of 1.2% in 4Q 2005 and declines of 0.3% in 3Q 2005, 1.2% in 2Q 2005 and 1.3% in 1Q 2005.
"Given that our surveys observed consistent declines in 2003 and 2004, the 1Q06 and 4Q05 surveys are notable as the first time in three years that we would have seen modest production growth, if it were not for the hurricanes."
But the improvement is not enough to affect gas prices, the firm said. "First, the hurricanes will have a very real and lasting impact upon U.S. gas production for several years. We can't simply pretend they didn't happen. Secondly, a 0.5% production increase is very modest given the 30%+ increase in the gas rig count over the past 24 months."
While drilling activity is up substantially, it's largely in basins that have very high initial decline rates, Raymond James noted. "That means it will be very difficult to keep up with current production trends without an even greater increase in the rig count. The bottom line is that we do not believe a theoretical 1/2% rise in domestic gas production can be extrapolated into long-term sustainable gas production increases."
The firm's energy analysts clearly see reasons to be bullish. "Going forward, constraints in rig availability are likely to become more pronounced, and gains in efficiencies should slow at the same time that higher decline rates begin to kick in and prospect quality continues to fade. This means that the U.S. gas supply picture remains quite constrained for years to come."
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