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Signals Point to Higher Gas Prices in Early 2010

Energy analysts have begun to write off any hope for natural gas prices moving higher this year, but some see signs of recovery by early 2010.

The energy team at Tudor, Pickering, Holt & Co. Securities Inc. (TPH) said last week the plunge in drilling activity from the peak in 3Q2008 should result in wellhead supply declining by 5 Bcf/d, or 8%, at the end of 2009 from year-end 2008. And that means a tighter market and higher prices.

"The die is cast for 2010," said TPH analysts Brian Lively, Dave Pursell and David Heikkinen. Their forecasts indicate gas wellhead supply over the second half of 2010 falling by 6.5 Bcf/d, or down 10% from year-end 2008.

Using data from nearly every producing well in the United States, the TPH analysts created a model to forecast U.S. gas supplies based on basin specifics and well production numbers. The model, said the trio, "is accurately forecasting various supply-side data points we are currently seeing in the marketplace," including Energy Information Administration 914 data and individual well data.

"The past dictates the future...production declines will lead to a tightening gas market," they wrote.

Based on the numbers, TPH increased its 2010 gas price forecast to $7.50/Mcf from $5.50. In 1Q2010, TPH is forecasting gas prices will average $7/Mcf, and in 2Q2010, it is forecasting gas prices to rise $1/Mcf to $8. Through the second half of 2010, gas prices are seen down slightly to average $7.50/Mcf. The 2011 gas price forecast was cut to $6.50/Mcf from $8.

By early 2010, a "much steeper" recovery is expected in oil service sector activity, with a "nice trade in gassy names," said the TPH team. However, "beyond late 2010, U.S. activity looks flattish at 1,500 rigs with too much oil service capacity. Cycle-to-cycle earnings will be lower for North American service companies."

The 2010 rig count is likely to increase, with oil-directed activity showing "steep increases," according to TPH. Incremental gas activity will be focused on shale drilling.

"We are entering an environment of 'haves' and 'have nots,' with the emergence of prolific gas shales," wrote the TPH trio. Exploration and production (E&P) "companies will be more shale focused and wary of conventional areas," and 2010 and 2011 "are likely the gas 'Wonder Year(s)'..."

On Friday the TPH team reacted to Energy Information Administration (EIA) 914 U.S. gas production data for June, which showed the fourth consecutive monthly onshore production declines, "but only 0.2 Bcf/d where we'd been looking for 0.7 Bcf/d." Meanwhile, Gulf of Mexico gas output climbed 0.5 Bcf/d on continued recovery from 2008 hurricanes.

According to EIA, total U.S. gas production rose sequentially in June by 0.3 Bcf/d at 63.3 Bcf/d versus 63.0 Bcf/d in May (see related story). However, the TPH team is sticking with its thesis that supply will be tighter by early next year.

"Bad optics and no catalyst from this month's data, but gas thesis of 'not enough supply' unchanged as steep declines [are] inevitable," said the TPH analysts.

Other analysts are forecasting higher prices going into 2010, but they also hold little hope for 2009. Credit Suisse earlier this month cut its U.S. price forecast for 2009 to $3.92/Mcf from $4.00, and sliced the 2010 estimate to $4.642 from $5.140. Weighing on the 2010 prices are expected increases in liquefied natural gas (LNG) imports and the start-up of 15 new coal-fired plants.

"Given the dramatic reduction in U.S. natural gas drilling, it is perhaps not too surprising that our forecast for domestic production calls for a sharp decline next year," analyst Teri Viswanath said in a note to clients. "What is surprising is that we believe that this significant drop in domestic production will have very little impact on natural gas prices."

Higher worldwide liquefaction capacity, combined with weaker global demand, will ensure stable U.S. supplies as rising LNG imports offset declining domestic production, said Viswanath.

"This is the first time we have expressed our views on 2010 balances and the unsettled feeling that we have could be likened to driving at night without headlights...While the passing landscape might look familiar, the uneasiness over hitting bumps in the road has exponentially increased."

The Credit Suisse forecast is based on the expectation that if all goes according to plan, North American gas output will be "heavily supplemented" by LNG imports. The estimate is for 2009 to round out with 1.5 Bcf/d of LNG imports and that figure to double to 3 Bcf/d in 2010. That prediction was accompanied, however, by a warning of the "real possibility that these imports will not emerge in time or in equal volumes to offset declining domestic production. This possibility poses a significant risk to our supply/demand projections and price forecast for 2010.

The second assumption in the Credit Suisse projection is based on the "somewhat surprising development" of the start-up of new coal-fired power plants (see related story).

Capacity from coal plant additions going online in 2009-10 will top 10,000 MW, with one-third of the baseload power, or more than 3,000 MW, showing up in Texas, Viswanath explains. While the great bulk of the 150 coal plant projects that were proposed between 2000 and 2006 were cancelled. Some were not. And it is these projects that will dampen natural gas demand.

Industrial demand should continue to recover in 2010, but Viswanath said it will be "significantly overshadowed" by losses in electric power demand. "In our view the start-up of a significant number of new coal-fired power plants will displace gas units in the dispatch stack, resulting in lower gas demand."

Separately, Barclays Capital analyst Jim Crandell said U.S. E&Ps "used 59% less rigs drilling for new supply, creating the expectation that supply would do its part to equilibrate markets," from last fall's peak drilling to this summer's trough. "At current levels of around 700 (where we expect the rig count to average through year-end), new production is not sufficient to offset declines from existing wells. To be clear, as the rig count has changed drastically, so too have the prospects for natural gas supply."

The numbers are bullish, but "sustained sequential declines in production do not look likely to help gas prices climb out of the cellar until winter begins dissipating surplus gas in storage," said Crandall. "While domestic supply looks unlikely to save 2009 prices, its effect should be felt in 2010, when production stands, on average, 3.15 Bcf/d lower year/year."

Standard & Poor's Ratings Services (S&P) last week also revised its short-term working assumption for Henry Hub gas prices to $3.75/MMBtu through the rest of 2009 based on a "relatively tepid" production decline and on weak industrial demand.

S&P credit analyst Thomas Watters said the long-term assumptions for gas reflect producers' cost structures, production decline curves and demand growth, according to S&P.

"We believe that while some of the best shale plays can generate fair rates of the return in the range of $4-5/MMBtu, the majority of drilling opportunities in the U.S. require $6-8 prices to be worthwhile," said Watters. In addition, the "typical decline curves for many of the unconventional resources plays, which are responsible for a high percentage of new drilling in the U.S., average 60-80%."

Over the long term, Watters said, "demand will be influenced by the attractiveness of natural gas for electricity generation. We think that due to environmental regulations and the increase in coal prices, natural gas is likely to be the fuel of choice for additional generating capacity."

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