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Interest in Shale Plays Points to Increased North American Drilling

Thanks to the newfound interest and favorable economics in natural gas shale plays across the country, North American drilling activity should remain steady through 2008 -- even if prices soften -- Raymond James & Associates Inc. analysts said in a note.

Analysts J. Marshall Adkins, James M. Rollyson and Collin Gerry had been bullish about international prospects, but they now remain "more comfortable" that drilling activity will hold up across the United States and in Canada.

"With front-month and strip natural gas prices steady above $10/Mcf, it is no surprise that domestic drilling activity is outperforming our previous forecasts," wrote the trio. "More importantly, E&P [exploration and production] operators continue to ramp up drilling activity in domestic shale plays as they become an increasingly large part of U.S. production. In Canada, the dynamics are similar to those in the U.S. except that, on average, the economic thresholds for E&P companies occur at higher energy prices (primarily due to the product price differentials and recently increased royalties).

"On the other hand, the international rig count has been increasing more slowly than we expected despite record crude prices. Given our updated price decks, the increasing importance of new shale plays and increased customer optimism, we now expect the domestic rig count to continually rise from current levels this year. All in, we are now calling for the domestic rig count to increase 4% year-over-year (y/y) and average 1,840. Internationally, our forecast still calls for a 7% y/y increase in the number of rigs drilling despite y/y growth below 5% thus far. We are also taking our Canadian rig count assumptions higher, and modeling a flattish outlook, inline with our Canadian team's estimates."

Drilling and production-oriented stocks have soared year-to-date, but there still is room for further upside given the momentum that the group has, said the Raymond James team. Investors, they said, have short-term trading opportunities, but they remain "hesitant beyond this summer" because of gas oversupply issues on increased U.S. production.

"Despite anticipated headwinds associated with falling natural gas prices, earnings improvement should follow the rig count upwards in 2008," said the analysts. Initially the Raymond James energy team was calling for the domestic rig count to decline by 4% y/y because of a summer meltdown in natural gas prices to $5/Mcf or lower. However, the second half of winter was colder than anticipated, which in turn pushed the analysts to a more bullish forecast for the year.

"Given the meaningfully colder second half of winter, our outlook for the summer is not nearly as bearish as it was just two months ago," the analysts wrote. "Natural gas has steadied above the $10/Mcf range, but activity levels are likely to remain robust even at meaningfully lower levels. First off, the floor on natural gas prices has risen by $1-2/Mcf to $5/Mcf in recent months due to surging coal prices. This is important because drilling economics in the unconventional U.S. shale plays (Barnett, Fayetteville, Woodford, etc.), which are becoming an increasingly important part of drilling activity, remain attractive at lower gas prices relative to most conventional gas fields.

"With finding and development (F&D) costs as low as $1/Mcf (estimated for the newly discovered Haynesville Shale), drilling economics in these markets encourage increased activity at natural gas prices above $5-6/Mcf, well below our new price deck. Activity increases should continue, especially considering that some of the recently discovered plays (Marcellus, Haynesville, etc.) have virtually no currently rigs operating," they noted.

With the 35% increase in gas prices since the beginning of the year, operators of all sizes have boosted their U.S. drilling programs, capital expenditures and production guidance.

"We also believe that small private operators, who require sustained higher prices, will begin to ramp up drilling activity and soak up some of the excess capacity as well," said the analysts. "This trend is starting to show up in the number of drilling permits filed. The two highest weekly permit totals this decade were recorded this April. There is typically a three-month lag between permit activity and drilling activity. For this reason, we are forecasting 2Q2008 to average 1,850 rigs drilling, nearly 5% higher than the 1Q2008 average of 1,770."

The combination of new equipment additions to flattening activity levels was a key driver in pricing pressure, said the Raymond James analysts. Now that stronger gas prices have led to a rebound in drilling activity, combined with far fewer new-build deliveries, pricing levels appear to have bottomed.

"If activity continues to improve, as we now think is likely due in part to the shale plays, what excess capacity exists today should be soaked up, eventually helping to turn the corner on pricing," they said.

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