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'Shaliest' Producers Seen Lifting Domestic Gas Output by 9%

Natural gas production in 3Q2009 by the top domestic explorers showed little sign of pulling back, and aggregate output by the end of the year could be 9% higher than in 2008, which points to "substantial uncertainties" for supply and demand drivers in 2010, energy analysts said last week.

A year has passed since the natural gas rig count peaked in October 2008, but "normalized" estimated quarterly gas supply from publicly traded producers didn't cross into negative territory until July from the 1Q2009 peak, noted Raymond James & Associates Inc. analysts John Freeman and Cory Garcia.

Freeman and Garcia reviewed 3Q2009 production data by public companies and compared the data with gas output over the course of the past year. For about a decade Raymond James analysts have been tracking reported gas production from publicly traded U.S. gas producers, which comprise about half of total domestic gas output. The latest quarterly survey points to another "strong" year/year (y/y) gas supply increase of 5.3%, or 1.6 Bcf/d.

"However, we would point out that this growth rate is artificially inflated given the supply disruptions caused by hurricanes Gustav and Ike in the prior year's quarter (3Q2008). Therefore, we come up with a more moderate y/y growth rate of 1.2% (0.4 Bcf/d) after adjusting these figures to reflect hurricane-related shut-ins," the duo wrote. "On the other hand, we believe that the combination of voluntary shut-ins, delayed natural gas well completions and pipeline constraints somewhat distorted and understated the 'true' 3Q2009 U.S. gas supply picture -- a theme that will continue to play a role in the coming months."

For most of the first six months of 2009, "what we've seen is a slow roll (somewhat of a plateauing effect) in production," they wrote. "In fact, we believe total domestic supply in 3Q2009 is only down 1-1.5 Bcf/d from the peak, illustrating the resilience in the growth curve of private producers as well. Turning to 2010, caution remains the name of the game as substantial uncertainties still exist for the key natural gas supply and demand drivers."

Three assumptions support Freeman's and Garcia's "subdued" natural gas price outlook of $5.50/Mcf on a full-year basis:

Natural gas futures are pointing to sub-$5/Mcf pricing through next May because "storage levels are now sitting above 3.8 Tcf, and there is a distinct possibility that we could see a net build in inventories this month. Second, on the demand front, we've seen only a minimal increase in industrial demand, which we believe is very likely to be offset by gas-to-coal switching in the coming months (a reversal from earlier this year). Third, don't forget about the LNG cargoes sloshing around the seas this winter.

"Lastly, and probably the most significant factor weighing on near-term gas prices, natural gas production has yet to show the hard rollover that many of the pundits (read: bulls) were pointing to throughout 2009. In fact, the results from last quarter's (3Q2009) public company U.S. natural gas production survey suggest that domestic gas supply is fading at only a modest pace."

Gas bulls should tread "lightly into some potentially bullish figures" from the upcoming Energy Information Administration's 914 production data for September and October "because this natural gas production 'slip 'n slide' has some underlying rocks ahead (i.e., a significant inventory of uncompleted wells, shut-in production), which should push the 'real' supply rollover out into 2010," said the duo. "So unless we see the semblance of a frosty winter, it's hard to get too excited about natural gas prices this winter."

According to an analysis by the exploration and production (E&P) research team at Tudor, Pickering, Holt & Co. Securities Inc. (TPH), most of the gas-directed E&P companies showed no signs of slowing their strong production growth in the last quarter, especially the "fastest growing, 'shaliest' companies." TPH covers 30 of the top-rated publicly held domestic gas producers.

Going into 2010, "we think overall cash flow for our coverage universe grows 25% (to $58 billion) as higher benchmark prices should drive higher cash flows with production growing only 9% y/y [year/year]," said the THP analysts. TPH now expects capital exploration (capex) budgets will be up 19% y/y "as E&Ps begin ramping activity during the year, supported by higher commodity prices, but they will be fighting against the production declines created by slower overall 2009 activity levels.

"We think of 2010 production as lower in the first half of 2010, higher in the second half," which would set up "nice 2011 volume growth (assuming gas prices don't make life difficult)."

Service costs fell drastically this year from 2008, but TPH expects costs to be almost flat -- gaining 1% -- in 2010.

"With higher cash flow expected in 2010 (plus 25%) we increased our capex outlook next year (plus-8%) and now forecast the sector plows back 77% of cash flow in 2010 (versus 90% in 2006-2008)." More of the cash is expected to be directed to increasing liquids production from the gas plays.

"We're forecasting overall plus-9% y/y [growth] in 2010, with liquids contribution to overall production growth increasing," said the TPH analysts. "Liquids growth is 8% y/y in 2010 compared to 7% in 2009, while gas growth is plus-9% in 2010 compared to plus-11% in 2009."

The TPH 2010 price deck is $7.50/Mcf for gas and $67.50/bbl for crude oil.

"Assuming the current 2010 strip ($5.35/Mcf and $82.95/bbl), 2010 plowback would be 79%," said the TPH team. "Assuming $6/Mcf, 2010 plowback would be 85%. Assuming $5/Mcf, 2010 plowback would be 91%, inline with 2006-2008 averages. So companies will be generating free cash for acquisitions, or their budgets will increase as gas prices rise. We bet some of both."

The TPH-covered universe has an estimated average 40% of total production hedged at $8.67/Mcfe (43% gas at $7.00/Mcf; 58% oil at $74/bbl). "We expect as gas prices move higher into winter months/early 2010, more companies will take advantage of opportunities to layer in additional hedges at more attractive prices, locking in cash flows for 2010 and even 2011/2012, depending on each company's views of the longer-term gas price outlook.

"Many are more cautious than we are for 2010 and more bullish than we are for the longer term."

Barclays Capital's Tom Driscoll last week reminded investors that gas storage "continues to set records -- and it would likely be even higher without infrastructure constraints and voluntary curtailments."

The 3Q2009 gas volumes "were fairly robust...even with company curtailments," said Driscoll. EnCana Corp., he noted, curtailed 500 MMcf/d of production in 3Q2009 and "most large producers have indicated further growth in 2010. We believe production remains too high and gas prices are likely to be weak over 2010."

The Barclays analyst said gas production capacity "appears very strong. We estimate the largest public companies, accounting for over two-thirds of U.S. natural gas volumes, had 3Q2009 gas volumes 1.5% below 2Q2009, and if volumes were not restrained, production would have grown quarter to quarter."

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