The U.S. exploration and production (E&P) sector has entered an energy "supercycle" as the market begins to realize the magnitude of "real" asset growth from the abundance of onshore reserves and the potential from liquids and natural gas shales, said FBR Capital Markets analysts.
The FBR Capital team, as well as several peer groups, in the past two weeks have been reviewing E&P stocks and capital expenditure (capex) plans for this year. Overall, the outlooks mesh: gas production needs to fall before prices increase. And they also agree about another thing: the turn to liquids and oily plays is improving the balance sheets of many independents.
"U.S. conventional natural gas production since 1950 has totaled around 1,000 Tcf," the FBR Capital team wrote. "Meanwhile, conventional liquids production from Lower 48 since the beginning of last century has totaled around 160 billion bbl. We believe that the industry will be able to recover similar amounts of both oil and gas from the shales. Therefore, we remain bullish on the sector and believe that the reserve growth-based 'real' energy supercycle has just begun."
Raymond James & Associates Inc. noted that at this time last year domestic gas production had begun to show signs of bottoming, following "modest" declines throughout most of 2009.
"Our year-end 2009 production survey of publicly traded operators actually showed a sequential uptick -- although many, including ourselves, believed that the quarter was simply inflated by end-of-summer injection season shut-in volumes. Surely production would resume its downward slide in 2010," said the Raymond James analysts in their review.
"In our relatively bearish base case scenario, we believed gas supply would fall through the first quarter and begin to level off in the spring of 2010. Instead of a declining 1Q2010 gas supply, by March 2010 our publicly traded universe was guiding to production growth (yes, growth) of almost 1 Bcf/d for 2010. Even weekly storage trends were beginning to loosen, implying more supply. Even the natural gas rig count had surged back above 900 (up 30%-plus from July 2008). It was all there. And yet, these supply growth warning signals fell on deaf ears."
Analysts with Tudor, Pickering, Holt & Co. Securities Inc. (TPH) said the "oily margins are simply too good to go back to gas." In a note the team said the margins on oil development at today's commodity prices are "clearly better than gas." But they are pondering what will happen once gas prices return to above $6/Mcf.
Will the "bigger gassy companies ramp up gas development or stick with higher margins in new oily plays such as the Eagle Ford and Bakken? We think the move back to gas is likely slower, even at economic gas prices. It's a simple strategy: there's only so much capital to invest -- put it to work in areas where returns are best."
TPH's analysts speculated that E&Ps may finagle a few more "big" joint ventures (JV) or acquisitions in the shales but more likely will be "numerous small deals. It's been a cost of capital/learning the shale game thus far, and with a lot of money still out there needing to find a home." North American energy plays, they said, "should continue to be a good place for Asian dollars to invest."
What's not likely to happen are JVs by the majors, said the analysts. "Majors won't go the JV route generally speaking (view: we can do that ourselves). They're buyers of assets," noting recent purchases by ExxonMobil Corp. and BHP Billiton in the Fayetteville Shale. "Expect more on the way. Where? Shales most likely, and don't just think oil. Fayetteville is 100% gas. Majors have longer-term investment horizons, and gas won't always be this bad."
And the "next oil play?" At some point, said the TPH team, "you'd think there wouldn't be any plays left to be found." At today's oil prices, "if there's oil out there, someone will find it. The Utica Shale in eastern Ohio is the latest big one...What's next? We don't know, but we're betting someone does."
Morningstar Senior Stock Analyst Jason Stevens expects natural gas fundamentals to improve over the course of 2011 as the gas-directed rig count shrinks. Morningstar's analysts "are beginning to see evidence of our thesis playing out as companies aggressively shift capex [capital expenditures] to liquids-rich plays.
"Falling gas-directed rig counts are a precursor to flattening, then declining, gas production in the U.S., though a one- to two-quarter drilled-but-uncompleted well backlog will support gas volumes after we've turned the corner," Stevens said. "We continue to expect gas-directed drilling to slow considerably in the second half of 2011."
Low gas prices, combined with "high service costs, less drill-to-hold acreage pressure and weak internal cash flow generation...will sap the desire and ability to perpetuate the presently high active gas rig count," said the Morningstar analyst. "Although this still argues for a weak gas price in 2011, it should set up better fundamentals for gas in 2012 and beyond."
The shift to liquids production also will "force higher gas prices over time," Stevens said, "as E&P companies will require attractive pricing before redirecting capex from high-returning liquids plays."
Even though gas-directed E&Ps have experienced "pain," said Stevens, "it's somewhat unusual to note that U.S.-focused oil and gas services companies have experienced a period of incredible pricing power over the past several quarters."
That pricing power has put the squeeze on E&Ps from "both ends, with lower gas selling prices and higher services costs, and earnings power has suffered." Morningstar analysts anticipate that services companies will maintain their current pricing power throughout 2011.
In response to the ample supplies, FBR Capital analysts adjusted their gas price forecast for 2011.
"We are maintaining our long-term natural gas price forecast of $5.50/Mcf but are lowering our full-year 2011 gas price forecast to $4.79/Mcf from $5.00/Mcf," said the analysts. "The lower gas price is reflective of a lower 1Q2011 price ($4.15 quarter-to-date average versus $4.50/Mcf forecast) and a reduction in 3Q2011 gas price forecast to $5.00/Mcf from $5.50/Mcf.
"The reduction in 3Q2011 estimate is driven by a bit slower-than-expected drop in natural gas drilling activity. Longer term, we continue to believe that current natural gas drilling economics are insufficient to sustain supply growth."
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