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E&Ps Urged to Adapt to Lower Gas Prices -- or Else

With steadily improving efficiencies in the drilling of onshore natural gas wells, most operators will earn a "decent living" if gas prices average around $5/Mcfe "and the others will adapt...or fade away," analysts with Raymond James & Associates Inc. said last week. Credit Suisse analysts also are pessimistic about gas price gains in 2010, and meanwhile, the FitchRatings credit ratings team lowered its gas price estimates to around $4 for the coming year.

Writing in Raymond James' Stat of the Week, analysts John Freeman and David Luke Eller said a combination of gas well high-grading, lower well costs and improving drilling efficiencies have combined to "substantially" lower the marginal gas well economics for exploration and production (E&P) companies over the past year.

"Think to yourself, when was the last time you heard a public E&P company state that their projects need over $6/Mcf for their play to make economic sense?" asked the duo. "Since the vast majority of management teams exclude 'nondrilling costs' when they calculate their internal rate of returns, we can argue until the cows come home whether that is right or not, but does it really matter if they are putting holes in the ground?"

Freeman and Eller calculated the most recent average returns for some of the major onshore gas shale plays to figure out the average costs to drill a horizontal gas well today. The calculations, they conceded, are only a temporary snapshot of current well economics because given what's happening as oil services continue to upgrade, the economics may continue to improve with time.

"Additionally, companies within the same play will have better or worse economics depending on acreage quality, cost structure, etc.," said the analysts. Improved drilling efficiencies have driven the marginal cost of gas production down sharply in the past year, by as much as 50%, they noted. "That said, it appears that adequate returns are being generated at near $5/Mcf."

The market "might be terrified of a $5 gas world," but oil service costs have fallen on average 30-40% from the peak, noted Freeman and Eller. "Tack on efficiency improvements and eliminate the least economic gas wells (amounting to 30-50% fewer gas wells being drilled), and all of a sudden E&P companies are making good returns at $5 gas prices."

Based on its concerns about a continuing oversupplied U.S. market, Credit Suisse last month reduced its U.S. gas price forecast for 2010 to $3.97/Mcf from $4.01 (see NGI, Nov. 30). Last week the analysts, including the equity oilfield services team, weighed in during a teleconference with their forecast for U.S. drilling and the implications for gas production in the coming year.

"The key conclusion in looking at 2010 versus 2009 is that we'll see a production decline of about 2.4 Bcf/d," said Credit Suisse analyst Arun Jayaram. It was easier to forecast onshore gas production before horizontal drilling took over for E&Ps, he said. Now the forecasting model is outdated.

"In our view the previous model is no longer valid, and the key reason is that the declines are not as great as they were modeled in from the shale plays," said Jayaram.

Credit Suisse's Brad Handler noted that it's difficult to ascertain what the rig count has to be to sustain production. "Our total U.S. forecast is very subdued," he said. "We see only growing to 900 rigs by 2012, and it's a function of our view that more rigs are not necessary to meet demand."

In 2010 Credit Suisse is forecasting a 750 gas rig count in the United States, with horizontal drilling continuing to dominate. "We are basically assuming that every added rig is horizontal," said Handler. "And gas-directed activity will be two-thirds of the horizontal market."

However, the "level of declines will be much less than the market is anticipating," said Jayaram. "Our analysis is very consistent with what we've done on the E&P side...The consensus viewpoint is for production declines in the range of 5-7 Bcf/d in 2010, but our work suggests it's closer to 2 Bcf/d...

"This trend to get better in 2009 given some early returns in places like the Haynesville and Marcellus. It makes us believe that the production base will look a little bit better in the future."

In a special energy report FitchRatings last week also cut the price deck for 2010 U.S. natural gas by $1/Mcf to $4.00/Mcf at the Henry Hub, down from an earlier forecast of $5.00. The crude oil price was lifted to $70/bbl (West Texas Intermediate) from $57.50 representing "expectations of stable demand," Fitch analysts said.

"The revision to our U.S. natural gas price deck represents continued supply/demand imbalances stemming from rising supply from U.S. shale plays and increased LNG [liquefied natural gas] liquefaction capacity," said the Fitch team. "While improved economic conditions should support demand for the commodity, Fitch does not currently expect demand increases to materially tighten enough to support prices during 2010."

Fitch's "stress case" price deck for 2010 is $3.50/Mcf for gas and $50/bbl for oil, which represents "reduced inflationary concerns and the potential for a 'double-dip' global recession."

Fitch's price deck is used primarily for modeling and rating purposes and tends to be conservative, but "it also represents our belief that prices will ultimately revert to levels driven by long-term fundamentals," said the analysts.

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