Signs of recovery in some sectors of the U.S. economy and rising consumer confidence have driven oil prices steadily higher in recent months, but other areas of the energy sector, including natural gas, have yet to be impacted by the “hope premium,” according to a report issued last week by Ernst & Young’s Americas Oil & Gas Center.

“In the past few years, there was a $20 to $25/barrel ‘risk premium’ added to oil prices,” said Marcela Donadio, who leads the center. “That premium has been replaced by a ‘hope premium,’ as markets believe an improving economy will spur significant demand increase. Major players in the energy industry are preparing for the upturn.”

For the U.S. gas sector, increases in upstream spending, drilling activity and infrastructure expansion led to a jump in output over the past two years. However, because of the depressed economy and an oversupply, demand continues to be weak, the report noted.

“When commodity prices collapsed at the end of 2008, leaving gas at $6/MMBtu, oil and gas prices were aligned in the $30/boe range,” the report noted. “While oil prices have bounced off the bottom and climbed as high as $70/bbl, natural gas prices have continued the downward march and are currently around $3.50/MMBtu, or $21/boe. On a barrel of oil equivalent basis, oil is now approximately three times the value of natural gas.”

Donadio said “recovery will be slow and gradual,” but “there is a great deal more optimism in the markets going into the third quarter and that is reflected in oil and gas industry activity.”

The oilfield services sector, which traditionally is last to feel the effects of a down economy, is now feeling the brunt of the credit crunch, according to Ernst & Young. The sector also is experiencing the effects of exploration and production (E&P) spending cuts and pressure to renegotiate contract rates for all drilling and production services.

“There is a trickle down effect for oilfield services,” said Charles Swanson, managing partner for Ernst & Young’s Houston office. “Earnings go through the roof in the good times, when demand for equipment and services is high, driving up the price. Likewise, earnings bottom out when E&P companies cut back spending.”

However, the “transactions landscape” appears to be stable, “and the start of the recovery may be at hand,” the report noted. Deal activity in the first six months of 2009 was down only slightly from the first half of 2008 when prices averaged $125/bbl.

“We anticipate the next wave of transactions coming soon,” said Jon McCarter, who leads the transaction advisory services unit for the Americas Oil & Gas Center. “There are weakened companies out there, ripe for the picking, and companies with strong balance sheets looking for quick growth opportunities.”

In a separate report, energy analysts with Raymond James & Associates Inc. said last week the fundamental differences between global crude markets and the domestic natural gas market are unlikely to return to the historic 7:1 ratio price-wise until U.S. shale gas reserves are depleted, gas demand infrastructure is enhanced or more domestic liquefied natural gas (LNG) export capacity is added.

In the Raymond James Stat of the Week, J. Marshall Adkins, James M. Rollyson and John Fitzgerald analyzed whether now is the time for investors to buy natural gas because it is “cheap” relative to crude. When the U.S. gas and global crude markets were considered balanced, basically from 1997 to 2006, the crude-to-gas ratio averaged out at around 7:1.

However, abundant shale supplies and a changing domestic landscape have forever changed the gas market, wrote the Raymond James trio.

“Our view is that the oil-to-gas ratio is largely irrelevant when the gas market is oversupplied since natural gas is not a truly global commodity (i.e., it isn’t easily imported/exported), and consumers have already switched to using as much gas as possible,” said Adkins and his colleagues.

New technology has rapidly advanced domestic gas supplies from unconventional — and conventional — plays, which in turn has created a “technology-driven natural gas supply bubble,” said the analysts. “If the shale reserve estimates are close to what is being advertised, the readily available gas supply will continue to pose a problem for gas pricing. In other words, this could be another gas ‘bubble’ that could drive gas prices lower relative to crude for an extended period of time.”

With time, gas prices should move toward the cost of increasing production to keep up with demand, said the Raymond James analysts. “Every time natural gas prices move high enough to grow production, excess supply should push prices back down.”

Domestic gas output, the analysts noted, was growing at 6 Bcf/d year/year when the “worst” performing wells (from around 1,600 gas rigs) were economic at around $8/Mcf. Since the gas rig count peaked last fall, more than half of the active rigs that were drilling have been laid down.

“As the ‘high-grading’ of gas wells has progressed, the marginal prospect has likely moved from the $8/Mcf range to below $6/Mcf,” said Adkins and his team. “In addition, service costs have dropped 30-40% over the past nine months. If the least economical prospect being drilled today (at $6/Mcf hurdle rate) sees a 40% cost reduction, then that well now makes sense in the mid $3/Mcf range, roughly today’s price.”

With only 700 gas rigs in operation, the question is whether the U.S. gas supply will continue to grow.

“Time will tell,” wrote the Raymond James trio. “Even if we need over 1,000 gas rigs running to grow supply, our guess is the marginal cost of the worst well will still make sense with gas prices in the $5-6/Mcf range. This analysis excludes any impact from restrictive legislation that could be passed with regard to drilling and completion activities.”

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