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E&Ps Seen Delivering Even if Gas Below $9

The fundamentals are in place for exploration and production (E&P) companies to spend more on drilling programs and deliver a healthy return on the money they spend, provided they earn a New York Mercantile Exchange (Nymex) natural gas price of around $8.75/Mcf, according to energy analyst John Gerdes.

Gerdes, of the SunTrust Robinson Humphrey/the Gerdes Group (STRH), came to his conclusions following a review of the 1Q2008 data of E&Ps in the STRH portfolio. The STRH portfolio, which includes some of the biggest gas-focused independents in North America, was 1.2% above the analyst's estimates in the first three months of 2008. Unleveraged cash expenses were in line with its projections.

Using an E&P "capital intensity" price of $5.25/Mcfe, which includes exploration expenses, and adding in unleveraged cash expenses estimated at an average $2.20/Mcfe, the "all-in" E&P costs for many of the top North American independents are around $7.65/Mcfe, Gerdes estimated. Moreover, because E&P gas price realizations "generally" reflect a 50 cent/Mcfe discount to the Henry Hub, putting the Nymex-normalized all-in cost structure at around $8.15/Mcfe. The additional 60 cents/Mcfe would be free cash flow.

Since early 2007 E&P capital spending has slowed to the historical norm of about 10% a year, the analyst noted.

"Given management's desire to spend sufficient capital to generate an industry competitive growth profile (10-15%), even in a low $9 gas price environment, the E&P sector is almost 20% free cash flow negative," said Gerdes. "Interestingly, the lagging financial accounting-derived DD&A [depreciation, depletion and amortization] rate of these E&P companies is about $1.20/Mcfe lower than the actual development capital intensity."

The lower rates, he said, "likely reflect a significant allocation of capital to unevaluated (i.e., nonproven, nondepleting) property, plant and equipment and suggests the likelihood of aggressive proven reserve bookings against the depletion cost pool."

If gas prices remain above $9/Mcf and crude remains higher than $90/bbl, E&P cash margins should expand "significantly this year," said Gerdes. Assuming $9.13 gas/$93.17 oil prices, E&P cash margins could rise 20% or higher and gross profit margins may expand by 60% or more, he said.

"Stronger margins should continue to encourage an increase in U.S. drilling activity this year," he said.

"Assuming the E&P industry remains comfortable budgeting capital spending +10% higher than cash generation, North American drilling activity next year should increase about 5%," said Gerdes. "To balance U.S. gas market fundamentals in '08/'09, our analysis suggests U.S. gas drilling activity should increase 2% in '08 and 5% in '09 and assumes Canadian gas-directed activity is flat this year relative to '07 and increases 5% in 09."

Notably, this trajectory of North American gas drilling activity and corresponding capital spending implies the U.S. E&P industry remains +10% free cash flow negative in '09. Through 2009, the E&Ps covered by STRH have hedged about a third of their commodity price exposure.

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