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E&Ps Expected to Reveal Lower 3Q Output, Less Spending Ahead

When exploration and production (E&P) companies unveil their 3Q2009 earnings reports in the coming weeks, listen for natural gas-weighted producers to detail the impact on the quarter from uncompleted wells and how much production was shut in across North America, according to energy analysts.

Specific issues likely to be addressed include tighter basis differentials, sequential production declines, 2010 spending plans and asset updates, analysts predicted.

"During 3Q2009 earnings calls, we expect companies to continue to 'talk' about production deferment across North America, though in reality, we believe not much of it will come about," said FBR Capital Markets analysts Rehad Rashid and Michael Jones. "Though early, during earnings season we would be looking for hints toward capital deployment for 2010. The final theme centers on continued efficiencies and discussions of new plays or extensions in discovered plays, such as the Eagle Ford, Bakken, Haynesville and Marcellus."

E&Ps will be "clearly focusing on realized prices in looking ahead to 2010 budgets," said analysts with Tudor, Pickering, Holt & Co. Securities Inc. (TPH). "While most are unlikely to commit to spending plans this early, we think tighter differentials, sequential production declines and the decision to allocate capital between exploration and development will be at the forefront of managements' minds."

"We estimate that average U.S. basis differentials tightened to a 22 cents/MMBtu discount to Henry Hub in 3Q2009 (versus $0.60/MMBtu in 2Q2009) due to lower Hub pricing and regional storage issues," said the TPH team. "This compares to the 2006-2008 average of a $1.03/MMBtu discount. Companies operating in the Rockies with Nymex [New York Mercantile Exchange] exposure hedged should see the biggest benefit."

Sequential domestic gas declines "should start to surface" in 3Q2009 reports, and many producers likely will "follow suit in 4Q2009 without a meaningful rebound in rig count/activity," said the TPH analysts. "Initial 2010 budgets likely are on par with '09 as most companies are waiting on better indications of gas prices. Supply declines should lead to higher gas prices, ultimately driving higher 2010 spending...but gassy companies are likely wait until mid '10 to revisit activity levels."

Although it's a "tough nut to crack," the TPH analysts expect to hear more about the backlog of uncompleted wells that are above normal activity. "We think the gas bears' bark is much worse than companies' bite. Admittedly, the number is difficult to quantify, but we've heard rumblings of companies having more uncompleted wells than they have actually drilled." It's "impossible to accurately quantify (no slide rules needed), but important to distinguish between 'normal backlog' and a decision to defer because of low prices." TPH estimates the "above-normal" uncompleted well count was 300-400 through the first six months of 2009 for the producers it covers.

In a "bottom-up analysis" of 37 E&P companies they cover (18.75 Bcf/d total), FBR's analysts estimated that domestic gas output was flat sequentially in 3Q2009 from 2Q2009. Of the 30 producers in TPH's coverage universe, 3Q2009 volumes were estimated to be 10% above 3Q2008 "likely due to '08 acquisitions," while sequential volumes from 2Q2009 "likely contracted an aggregate -2%" because of lower onshore activity.

In any case, the analysts expect to see a substantial shift toward more oil-directed activity in 2010, specifically in the Permian Basin, Bakken Shale and in California.

"With bank redeterminations under way and a shaky strip price, we expect initial '10 gassy budgets to be modest, particularly for conventional projects," said the TPH team. However, higher gas prices in the first half of 2010 could drive activity higher in the second half of next year.

Even though they believe gas prices bottomed in 3Q2009, FBR's "supply/demand analysis does not support a rebound in prices to the $6.35/Mcf consensus expectation for 2010 but instead supports only a $4.50/Mcf number," said the duo. "We note that we continue to believe that a $6/Mcf natural gas price is not needed to drive the desired outperformance. For the rest of this year we remain focused on reserve volume-driven asset value growth."

FBR analysts maintained their 4Q2009 gas price estimate of $3.75/Mcf, "as we believe that current cash Henry Hub prices of $3.20/Mcf -- as opposed to November New York Mercantile Exchange of $5/Mcf -- are reflective of realities of excess physical supply."

For TPH analysts, their macro study continues to point to a "bullish 2010," even if recent performance "has forced us to rethink relative valuation. E&P stocks are currently pricing in $6.40/Mcfe and $5.70/Mcfe (assuming longer-term crude:oil ratios of 10:1 or 14:1). While no two markets are alike, we've kept our July 2008 valuation sheet pinned to our walls as a reminder...Momentum behind commodities can and will push E&P stocks higher...but huge valuation gaps between equities and underlying assets worries us."

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