The potential for a late summer natural gas price collapse may not be as high as analysts had predicted a few months ago, thanks to hotter-than-expected weather and a moderation in gas supply going forward, but prices aren’t expected to gain much strength for some time, energy analysts predicted.

U.S. gas supplies now sit “comfortably above the peak levels achieved prior to the massive rollover in the rig count in late 2008/early 2009,” and the largest publicly traded independents still are projecting gas supply to be up “a whopping 7%” year/year (y/y) in 2010, analysts with Raymond James & Associates Inc. said recently.

“Despite the fact that U.S. gas supply has grown much faster than market expectations, gas demand has grown even faster,” said analysts J. Marshall Adkins, John Freeman, Collin Gerry and Cory Garcia. “On the demand side, industrial gas demand has rebounded strongly this summer but the biggest surprise has been the spike in weather-related gas demand.”

According to the National Oceanic and Atmospheric Administration, weather-related gas demand this summer was up in mid-August by an estimated 200-350 Bcf over normal adjusted weather demand. “Clearly, the intensity of the hotter-than-normal weather this summer has been the primary reason U.S. natural gas prices have not fallen below $4.00/Mcf this summer,” said the trio.

In addition, domestic gas supply growth appears to be slowing, even though the gas rig count is up by about 50% since it bottomed in July 2009 and even though there’s been a shift to activity in more prolific horizontal plays.

Several things may be leading to a slowdown in domestic gas growth, the Raymond James analysts said. Lower gas production from the Gulf of Mexico because of the drilling moratorium, bottlenecks in pipeline takeaway capacity, constraints with hydraulic fracturing crews, delays in gas processing plants, a reduced benefit from the early 2010 de-bottlenecking of gas supplies that had been shut in last fall, and the high decline rate from horizontal shale wells all are moderating the growth numbers.

In Raymond James’ 2010 survey of reported gas production from publicly traded U.S. producers, which comprises about half of total U.S. gas output, the numbers appeared to confirm the Energy Information Administration (EIA) Form-914 data. In late June EIA reported that U.S. gas output across the Lower 48 states in April nearly matched production in March, and was 2.6% higher than in April 2009 (see NGI, July 5). The Raymond James survey of production from April through June showed that gas supplies increased y/y by 3.7% (or 1.1 Bcf/d).

If not for one of the warmest summers in recent history, “we remain convinced that we’d be looking at gas prices well below $4.00/Mcf,” said the Raymond James trio. “That said, recent production trends have even us, the popularly coined ‘perma-bears,’ a little nervous…” As to what this may mean for 2011 production, “the short answer is, we don’t know.”

Stephen Smith Energy Associates estimated in a separate report earlier this month that Lower 48 onshore gas production rose 2.5 Bcf/d from December through May. Gas rigs also have risen almost 5% since the end of May.

“Before any adjustments for potential hurricane and/or storage congestion effects, our projection would reach 4,095 Bcf at its November peak, which is well over last year’s 3,849 peak…,” said Smith. “Assuming 160 Bcf of production losses because of hurricanes and/or storage congestion, this projection would be reduced to 3,872 Bcf on Oct. 29 — about 85 Bcf above the late October storage level for last year.”

Historically, noted Smith, the most important driver of domestic onshore gas output capacity has been the gas rig count, but this effect now is being diluted by the “increased impact of widespread use of hydraulic fracturing.” The Baker Hughes gas rig count jumped by nine rigs to 992 rigs for the week ending Aug. 13.

Despite all of the reasons that gas supplies may be tightening, said the Raymond James team, “the flattening of the natural gas futures curve since early May — with 2012 contracts falling by 50 cents/Mcf and 2015 contracts by a whopping $1.00/Mcf over that period — sends a clear pricing signal that the market believes low gas prices and easy gas production growth are here to stay. We agree.”

Gas prices are weak and will remain that way into 2011 because of abundant supplies and weak demand, Merrill Lynch, the investment banking arm of Bank of America Merrill Lynch (BAML), said last week. Analysts slashed their forecast for U.S. prices in the final three months of 2010 by 16% and revised their outlook for gas prices for 2011 downward by 17%.

“We expect another weak gas market in 2011, with record production depressing prices,” Merrill analysts said. “Low natural gas prices are likely required for an extended period of time in order to constrain horizontal gas drilling and encourage demand.”

The domestic gas rig count hovered near the 1,000 mark last week, up about 42% from the year-ago period. The horizontal rig count was approaching a record 895.

Merrill’s forecast gas price in 4Q2010 now is set at $4.80/MMBtu, down from an earlier prediction of $5.60. The 2011 forecast was reduced to $5.00/MMBtu from $6.00.

Gas prices have support at current levels even though U.S. gas forward prices “have gone into a tailspin,” noted the Merrill team. Forward prices are “unlikely” to dip below $3/MMBtu as they did in 2009 because more “robust baseload power demand and continued hot temperatures” point toward a lower end-of-season working gas storage level.

“The 12-month forward strip now prices at $4.50/MMBtu, down from $5.15/MMBtu at the start of August and $6.20/MMBtu at the start of the year. In fact, every single strip out to 2015 now sits below $6. Against our expectations, even very long-dated U.S. natural gas prices from 2013 onwards sold off,” analysts noted. Since last year, noted the Merrill analysts, drilling in shale plays “has displayed virtually no sensitivity to gas prices at all.” BAML is projecting U.S. gas output to grow by 0.9 Bcf/d in 2010 and 1.7 Bcf/d in 2011.

Analysts noted that production in the Haynesville, Marcellus and Eagle Ford shales, as well as the Granite Wash play, have skyrocketed since late 2009. “These plays are proving to be extremely dynamic, benefiting from continued improvements in gas rig efficiency and well productivity. In the Haynesville alone, production is up about 2.4 Bcf/d this year relative to last.”

The number of producing wells has risen sharply over the past months, noted the Merrill team, “and the inventory of permitted wells waiting on completion, [hydraulic] fracturing or other operations is large. Permitted wells that are not yet drilling are also back at a record high. Shale gas is still leading the way. The summer heat has given gas demand an “immense boost,” but “assuming a return to more normal temperatures, BAML believes that the balance next year could turn out to be worse than this year.”

Gas price “inelasticity partly highlights the lower break-even costs of nonconventional gas plays,” said the Merrill analysts. “Break-even economics in some shale plays may be as low as $3/MMBtu. Moreover, a shift of focus within the industry to condensate and NGL [natural gas liquids] plays like the Eagle Ford in South Texas have also been driving the drilling recovery as liquid production boosts revenues. Furthermore, production costs have gone down due to efficiency gains.” With “strong demand” for high-end horizontal gas rigs, “even if the rig count declines, these highly efficient rigs which reduce drilling times are likely to continue to work.”

To exacerbate the abundance of U.S. gas supplies, Canadian drilling now appears to be going through a recovery, noted the Merrill team. Canadian gas exports to the United States continue to shrink, but “they are doing so at a lower pace amid signs that the supply decline could slowly come to an end.” Like the United States, “the recovery is geared to deep and horizontal wells tapping shale or other unconventional reserves, especially in British Columbia.”

However, liquefied natural gas imports “will unlikely be an issue,” and will average marginally above this year’s level, the Merrill analysis said (see related story).

Industrial gas demand “is likely to pick up on lower prices and major gas consumers like aluminum producers will shift back” to natural gas, said analysts. “There is enormous pent-up demand from the electricity sector as power producers will be building more natural gas-fired power generation plants in the coming years. Combined, this should put upside pressure on U.S. natural gas demand, and eventually U.S. natural gas prices in the medium term.”

Analysts with SunTrust Robinson Humphrey/the Gerdes Group (STRH) agreed on Wednesday that “gas prices do not appear poised to pop. With gas-directed drilling activity at 985 rigs, the industry is 30% free cash flow negative this year. A similar outspending of cash flow next year would likely lead to a $4.50-plus price, only modestly above current prices and partly due to lower expected cash flow from hedges.

“On the other hand, prices should not drop much, either,” said STRH analysts. “Coal-to-gas fuel switching should place a floor on gas prices near current levels as we expect an incremental 2-3 Bcf/d of gas-fired power demand.”

Meanwhile, Barclays Capital analysts said on Tuesday that “at just short of 1,000 rigs, with a focus on highly prolific shale wells, the rig count should lead to sequential growth in U.S. production unless rigs are taken out of service.”

Barclays analysts expect the rig count to drop in 4Q2010 “but there are various nonprice-related factors to watch for in coming months that will likely determine the amount of drilling ahead.”

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