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Gas Inventories Seen Pressuring Prices into 2010

Producers are laying down natural gas rigs in some of the most prolific basins in the United States, but it's not coming fast enough to eliminate reserves growth, which could lead to an all-time inventory high by this time next year and pressure gas prices for at least another year, energy analysts said last week.

Barclays Capital pegged gas prices in 2009 to average $6.36/MMBtu, with a rebound unlikely before the spring of 2010. Drilling is expected to remain slow in 2010, which would slow output, but "the storage overhang is unlikely to be worked off until mid-year" 2010, said Barclays' George Hopley, Biliana Pehlivanova and Michael Zenker.

The price weakness forecast next year may not rebound before well into 2010, when the analysts see prices averaging $7.16/MMBtu.

The "sell-off across all asset classes, the rapid decline in oil prices in particular, and the now global slowdown of the economy certainly played a role, [but] the downward slide of cash and forward [gas] prices is mainly driven by the growing imbalance between supply and demand," the analysts wrote. "More specifically, the seemingly unstoppable growth in U.S. supply has set the direction for prices and continues to drive our price outlook going forward."

Supply/demand balances "are looking increasingly loose," said the trio. Between January and August, gas "output was up a healthy 4.3 Bcf/d year/year (y/y), compared with a 2.2 Bcf/d annual up-tick in 2007." The growth was highest in Texas and the Rockies, where unconventional fields "are yielding wells with higher initial flow rates and slower second- and third-year declines than those for the average conventional wells."

Barclays estimates "now point to domestic natural gas production growth of 3.23 Bcf/d in 2008 and growth to continue into 2009."

Gas storage levels by the end of March may be "just over 1.8 Tcf, assuming 10-year normal weather," said Hopley and his team. "In a typical injection season, the market usually adds about 2 Tcf to inventories between April and October (the summer build averaged 2.04 Tcf in 2001-07). A similar build would put the end-of-October 2009 storage level at an all-time high of 3.8 Tcf, which would serve as a test to the nation's working gas storage capacity."

Partially offsetting U.S. gas growth will be "pronounced weakness" in U.S. gas imports, noted the Barclays analysts. Canadian pipe imports and liquefied natural gas (LNG) receipts "have waned this year, together reducing supplies nearly 2 Bcf/d on average compared with 2007. But the drivers of the declines for the two sources of imports diverge, and while Canadian imports are expected to continue falling, with 2009 averaging 0.75 Bcf/d lower than 2008 levels, the y/y comparisons for LNG will improve, albeit marginally, in 2009."

Even though nameplate liquefaction capacity is set to grow 6.1 Bcf/d next year with new facilities ramping up, U.S. LNG imports are seen averaging 1.2 Bcf/d in 2009, allowing for a y/y increase of 0.25 Bcf/d, "as occasional spot cargoes are pushed into the U.S. despite uncompetitive prices during seasonal troughs in demand in Europe and Asia."

Natural gas demand is unlikely to show strength in the coming year, but weather poses an upside risk, the analysts noted. Overall in 2009, Barclays is forecasting gas demand to average less than 0.1 Bcf/d higher y/y, and to strengthen nearly 1.0 Bcf/d in 2010 as the economy recovers.

Stephen Smith Energy Associates (SSEA) agrees with a lot of Barclays' findings. SSEA said last week that the growing gas surplus, low oil prices and an expected resurgence in LNG imports could keep Henry Hub prices below $7/MMBtu for "much or all" of 2009 and 2010.

"We expect Henry Hub prices to trade generally in the $5.50-7.50/MMBtu range for much of the 2009-2010 period," SSEA analysts noted in their monthly energy report.

After peaking in July, U.S. gas prices and world oil prices began their precipitous slide. "Since July, residual fuel oil (RFO) prices have declined by two-thirds, and the Henry Hub price has declined by half," noted SSEA.

"The global financial panic and related concerns about global oil demand was the main driver for the crude oil and RFO price collapse," the SSEA analysts noted. U.S. gas prices "declined partially in sympathy with oil prices, but also because of the extraordinary supply response from technology-driven U.S. gas shale plays over the past two years."

Now as the end of 2008 approaches, the current price levels for oil and gas are "looking more like the new 'steady state,'" the SSEA analysts noted. Part of the blame for lower prices was put squarely on OPEC, which last week delayed a decision to reduce oil exports. And until global oil demand rebounds, more LNG imports will head to U.S. markets, SSEA predicted.

"This implies that the task of rebalancing supply and demand in the North American gas market is not simply a question of waiting for lower rig counts to reduce North American gas production," wrote the SSEA team. "The time required for rebalancing the North American gas market is likely to be extended by the potential importation of excess global LNG supplies. We expect to see oversupplied North American gas markets for all of 2009 and probably all of 2010."

SSEA's gas rig outlook for 2009 and into 2010 also is as pessimistic as forecasts by other consultants and energy analysts. SSEA predicts "an ultimate decline of 15-20% before a new natural gas supply/demand equilibrium is established." Analysts with SunTrust Robinson Humphrey/the Gerdes Group (STRH) are no more optimistic.

"Significant rollover in land drilling activity should continue to present a strong headwind for the land drilling segment near-term (at best market performance), although valuation appears compelling long-term," STRH analysts said in a report Friday. "A 30% reduction in gas-directed drilling activity in '09 (1,000 average rigs) should moderate U.S. production sufficiently to reestablish market equilibrium assuming a further 20% improvement in rig/well productivity."

Given that the exploration and production (E&P) industry "intends to spend at or within cash generation against the backdrop of weak credit market conditions, a $6.50-7 gas price should lower U.S. drilling activity 30% next year," STRH analysts wrote.

The share prices of a lot of "quality" E&Ps have been suffering along with everything else, noted SSEA. In its review, the analysts found that a lot of U.S.-based E&Ps are selling at discounts to their "conservative" net asset value/share when computed using with a combination of $45 West Texas Intermediate crude prices and $6 Henry Hub sustained. And that price slump is expected to continue for a while.

Although positive on the long-term prospects for gas prices and E&Ps -- that is, 12-18 months out -- SSEA analysts said that "in the short term, we are more pessimistic." Traditional valuation "remains hostage to global financial markets in uncharted waters. The U.S. gas market appears oversupplied for 2009 and probably much of 2010."

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