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Raymond James Survey: Independents' Production Growing

U.S. natural gas production by publicly traded companies rose 5% in 3Q2006 -- the first time absolute year-over-year growth was visible in four years, according to a Raymond James Energy Industry Brief. Most of the growth though, was the rebound following the hurricane-related production deferrals in late 2005. Removing the storm impact, U.S. gas production actually is down about 0.3% year-over-year, implying higher gas prices in 2007.

What is notable about the latest survey is the impact by publicly held, independent exploration and production (E&P) companies, said Raymond James analysts J. Marshall Adkins, Wayne Andrews and Pavel Molchanov. The independents' U.S. gas output rose an estimated 7.3% (excluding the hurricane impact) in 3Q2006.

"Ex-hurricanes, we would estimate the growth rate at only 1% to 3%," the analysts wrote. The results "may seem mediocre compared to the massive level of investment," but "it is important to note that even at current (still somewhat depressed) gas prices, these companies are making strong returns on almost every prospect they drill."

Just a few of the independents covered by Raymond James drove most of the group's growth. Without the "impressive organic growth" from Chesapeake Energy Corp., EnCana Corp., EOG Resources Corp., Ultra Petroleum Corp., Williams Cos. and XTO Energy Corp., "the E&P group's year-over-year growth would not have been 7.3%, but rather 4.5%."

The E&P survey coverage is for only about 55% of total U.S. gas production, and the results are not necessarily reflective of the other 45%, which mostly consists of smaller, privately held E&Ps.

"Given the vast number of these smaller players, it is difficult to get an accurate assessment of what their production is doing," noted the analysts. "However, we do know that over the past 12 months the number of gas rigs among companies outside our survey rose 12%, less than the 16% increase among public producers [independents and majors]...Given this, plus the fact that drilling inventories among private companies tend to be smaller than that of larger public companies, we believe that their 3Q2006 production posted minimal (0% to 2%) growth on a year-over-year basis (adjusted for hurricanes) and may have even declined."

The analysts "added back" gas production from the hurricane-related shut-ins to the post-hurricane quarters (4Q2005 through 3Q2006) to calculate the underlying year-over-year change. "For 3Q2006, we still add back, but now we do it to the quarter in which the hurricane disruptions occurred -- in this case, 3Q2005."

The Department of the Interior's Minerals Management Service estimated about 196 Bcf of offshore production was deferred in 3Q2005, an average of 2.1 Bcf/d. The Raymond James trio did not calculate specific deferrals from its coverage group, "but given that the majority of offshore production is operated by relatively large, publicly traded companies, we estimate this figure at no less than 60%. If we use 65%, we would 'add back' 1.4 Bcf/d to our survey's reported 3Q2005 production."

The adjustment, which the analysts acknowledged is imprecise, yields an underlying year-over-year decline rate of 0.3% in 3Q2006, as compared with growth of 1.4% in 2Q2006, 0.5% in 1Q2006 and 1.2% in 4Q2005. The surveys have observed consistent declines between 2002 through mid-2005, and even though the prior three quarters indicated slightly positive production growth, "it now seems that even those modest gains may have come to an end."

U.S. gas production "has basically flat lined on an ex-hurricane basis." A lot of the recent incremental drilling activity has occurred in basins with high initial decline rates, including the Barnett Shale, where year-one production declines are about 50% or higher. "That means it will be very difficult to keep up with current production trends without an even greater increase in the rig count."

The independents' gas rig use has risen at a higher rate than the majors' -- up 19% year-over-year -- but the group still barely moved the needle on U.S. gas supply.

Despite the doubling in gas drilling activity over the past four years, "it is unrealistic to expect accelerating growth, given widespread shortages in the availability of rigs, other services and skilled labor for the E&P industry. We also note that our surveys cover about 50% of U.S. gas production. If production from these companies -- which have some of the best prospects, talent, and access to capital -- is flat lining, substantial growth from the small, mostly privately held, producers outside our survey does not seem feasible."

The steeper 2002-2005 organic declines in U.S. gas production "appear to have moderated (at least temporarily)," but getting to this point "took immense effort by the industry. The E&P industry is now at virtually 100% utilization of onshore gas rigs, and gains in rig counts and drilling efficiencies have been significant in the past four years.

"Going forward, constraints in rig availability are likely to become more pronounced, and gains in efficiencies should slow at the same time that higher decline rates begin to kick in and prospect quality continues to fade. This means that the U.S. gas supply picture remains quite constrained for years to come."

Price-wise, the bullish Raymond James group expects gas prices to remain depressed relative to crude oil in the short-term and gain in the long-term.

"Heading into 2007, as the storage surplus works itself out, we would expect U.S. gas prices to rebound back to the traditional 6:1 Btu parity with crude oil and potentially even higher, depending on the weather. While short-term gas prices and oil/gas price ratios will continue to be volatile, if oil prices remain near the $60/bbl level, this would imply fair value for gas close to $10/Mcf."

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