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Return to 'Heroic' Gas, Oil Prices Not Likely, Says Moody's

A return the "heroic oil or natural gas prices" of recent years is not on the horizon, and in fact, prices likely will fluctuate seasonally between $3/Mcf to $5/Mcf over the next 12 months and average under $6 for at least a year after that, a Moody's Investors Service analyst said last week.

"Many of the transitory causes have passed" for higher gas prices, wrote Moody's Senior Credit Officer Andy Oram. He contributed to a Moody's commentary on the outlook for global corporate finance. "We expect slow demand recovery and, specific to natural gas, glutted storage has to be worked off, and ample prompt supply from the gas shales looms...

"Longer term, the long awaited world surge in liquefied natural gas (LNG) capacity may finally create a deep world LNG market within three years. U.S. LNG imports would rise because that country is the only one with massive gas distribution and storage capacity. Many non-U.S. LNG producers also get good returns on associated natural gas liquids production, which may enable them to price LNG quite competitively into the U.S."

For the foreseeable future, credit conditions remain "cyclically negative" for the global energy sectors, and U.S. gas-weighted exploration and production (E&P) companies face "secular excess capacity pressures," Oram wrote.

Although spot gas prices moved higher last Thursday, Oram noted that spot prices opened at $3.26/Mcf on July 10, which was "far under strip pricing on industrial demand contraction, still durable production growth, and historic natural gas in storage...Average U.S. prices actually realized at the wellhead on unhedged production are lower still, and well below $3/Mcf in key regions."

Oil prices have retreated as well, Oram said, because of "recurring bad unemployment numbers, troubling ongoing unseasonal refined product inventory growth, renewed fears of a delayed and tepid recovery and some dollar firming." Moody's is forecasting world oil demand to fall about 3% in 2009.

Mirroring comments by other energy analysts, Oram said some E&Ps could face more pressure well into next year.

"Producer cash flows and liquidity could be pinched even more as hedge portfolios roll into lower prices and banks redetermine leveraged E&P's borrowing bases under less robust 2010 price assumptions than last spring," Oram noted. "E&P's relative operating strength relates to the degree to which production and reserves can be replaced at costs amply within cash flow. If elastic all-in costs continue to adjust down, cash margin coverage of sustaining capital needs may improve."

Producer costs are coming down, but those costs "come out of the drilling/oilfield services [OFS] sector's hide," said Oram. "As falling oil and gas prices hit producers' unhedged cash flow, reduced cash flow reduces their spending, and this progressively cuts into drilling/OFS pricing power. Negative momentum could continue well into 2010 as spending cuts progress through the OFS functions and older contracts roll off."

The drilling rig count is forecast "to rise gradually," but "the revenue impact would be muted by soft pricing and roll-off of higher-priced contracts," said the analyst. "Onshore providers of lower specification rigs have been hit worse than high specification rigs. The former is used more for vertical drilling (down over 60%), while the latter is used in horizontal drilling (down less than 40%). Generally, international drilling/OFS activity holds up better than U.S. activity due to less volatile integrated major and national oil company capital spending."

E&Ps and integrated majors "would likely be the first to move to stable or improving status," according to Moody's. "Even absent strong price recovery, stable conditions could emerge if reserve replacement and production costs adjust sufficiently. For natural gas-weighted U.S. E&Ps, stability may be complicated if fears of sustained oversupply are realized."

Recovery for the drilling/OFS sector "may lag by six to 12 months," said Oram. "That sector's task is to display cost structures that fit expected revenues from producers' expected spending. But this could be complicated too by the ongoing surge in newly constructed high-specification onshore and deepwater offshore drilling rigs. These rigs would crowd out lower-quality rigs unless drilling activity recovers sharply."

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