Bank of America Merrill Lynch analysts cut their 2010 U.S. gas price forecast to an average of $5/MMBtu from $6 on the expectation of rising production from shale plays, which might only be thwarted by even lower prices still, they said.
"Unless even lower prices force producers to slow down horizontal drilling, natural gas production could soon recover to last year's levels. On top of that, rising LNG [liquefied natural gas] imports and a sluggish demand recovery could also weaken the balance this summer," the analysts said in a note last week.
Even as prices founder, horizontal drilling continues in shale plays such as the Haynesville, Marcellus and Eagle Ford, the analysts noted. "...[T]he horizontal rig count started expanding gradually and has recently jumped to a new record high of 700 from a low of around 370 last June. Given that drilling still declined elsewhere, horizontal rigs now make up 50% of the total rigs in the United States. This development suggests that the industry can now operate financially at lower prices."
Citing research by the bank's equities group, the analysts said the marginal cost of production for U.S. gas is set by vertical wells and is $6/MMBtu, assuming a 10% internal rate of return. This figure is the basis for the analysts' gas price forecast.
"Break-even costs in the major shale plays can be substantially lower, ranging from $1.50/MMBtu to $3/MMBtu in the Marcellus Shale to less than $4/MMBtu in the Haynesville, suggesting that producers in these areas can make money at current prices," the analysts said. "...[W]e expect the marginal cost curve to shift to the right as shale gas production expands, putting downward pressure on marginal costs."
They also noted productivity gains in gas shale plays. Initial production rates in the Haynesville have averaged 15 MMcf/d, compared with those in the Barnett Shale of 2.4 MMcf/d. On the strength of the shales, the analysts are expecting "a relatively shallow decline" in production this year of 0.52 Bcf/d.
Domestic production that refuses to slow down is one factor contributing to the oversupplied market; LNG could be an even bigger risk to the bullish case, the analysts said. About 3.5 Bcf/d of global LNG liquefaction is slated to come on line this year, they noted.
"U.S. natural gas futures contracts are trading above the equivalent UK contract through September, likely attracting LNG flows to U.S. shores," they said. "Moreover, [Russia's] Gazprom just announced it would start to peg some European gas export volumes to spot gas prices instead of oil indexation [see NGI, March 8]."
If Russia is successful in winning European market share for its pipeline gas back from LNG, it would free up more LNG supplies, which could then come to the United States.
On the domestic demand side the chemical sector is leading improvement in industrial demand, but it isn't much, the analysts said; refining and the steel/metals sector are still weak. They project that industrial gas demand will recover 2.9% this year over last. "We find it hard to believe that this sector will support demand sufficiently to tighten up the [gas supply] balance," they said.
That leaves demand from gas-fired power generators, and gas prices are again expected to fall through the coal floor as they did last year, the analysts said.
"Gas can afford to price at or below coal parity in order to induce drilling cutbacks as there will be sufficient supply to cover demand," they said. "In our view, the balance in the market will increasingly weaken this year, putting some downward pressure on prices this year and next."
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