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NatGas Prices to Trend Toward $3.75 Average For 2016, Says Bernstein

Oil prices should recover "stronger and swifter" than many believe, while natural gas prices appear to be trending higher for 2016 as oil-associated output falls off, according to Sanford Bernstein.

However, a Morgan Stanley & Co. International analyst sees a longer path to price recovery and possibly “a downturn that may last longer than some initially thought."

"Our research on underlying decline rates and connecting rig count to production implies that the supply response will become increasingly visible in the third quarter," as lagged data becomes available, "causing price to rebound," said senior analyst Bob Brackett of Sanford Bernstein. He and his team tracked 40 North American-focused producers.

"We expect gas prices to trend towards a $3.75/Mcf average in 2016 as oil-associated gas production drops off," Brackett said in a note Thursday. "However, we believe that there is a large amount of gas that becomes economic at prices above $4.00/Mcf and therefore do not expect gas prices to go beyond that level for the foreseeable future."

As earnings season begins in earnest for the exploration and production (E&P) companies, Brackett said he would be paying attention to 2Q2015 volume growth, commentary about capital expenditure (capex) and rig plan changes.

The large- and medium-cap North American independents have begun to issue their second quarter earnings results, with the majors and several big independents scheduled next week that include ExxonMobil Corp., Chevron Corp., Royal Dutch Shell plc, BP plc, Statoil ASA, Total SA, ConocoPhillips, Hess Corp. and Anadarko Petroleum Corp.

"This quarter, we believe that investors will be focused on how E&Ps are handling the sharp reduction in cash flow," Brackett said. Also on the checklist are the Marcellus Shale gas differentials.

"Last quarter, we discovered that some Marcellus operators realized better differentials than we expected as a result of locking in fixed price contracts that looked good against a Henry Hub benchmark that didn't spike up as high as last year. We will see if this continues into the second quarter."

There is not a consensus on a swift price recovery for oil. Several "good reasons" favor a "recovery scenario," but it may take longer than envisioned, said Morgan Stanley in a report overseen by Martijin Rats. The E&P industry "is hunkering down” for a downturn that may last longer than some initially thought.

The choice now is between two investment themes, according to Morgan Stanley. In the first scenario, the industry recovers, with costs and capital expenditures (capex) down sharply, oil prices recovering somewhat, higher downstream profits and free cash flow (FCF) restored to a level above the dividend.

But the industry could take a long time, particularly if there is sustained high production from Saudi Arabia, a return to the oil markets by Iraq and a possible recovery from Libya. In this more pessimistic scenario, tight oil production from the United States "surprises to the upside, keeping oil prices below $60/bbl for a protracted period, say three-plus years," wrote Rats.

U.S. tight oil production growth has begun to roll over, but it has been more than offset by OPEC, which has added 1.5 million b/d since February. "Our commodities team currently sees the oil market as oversupplied by 0.8 million b/d," analysts said. "Hence, the entire current oversupply can be attributed to OPEC supply growth over the past four months alone. We had not anticipated this to such an extent."

At a long-term $60/bbl price, the oil majors still could develop a few projects profitably, "but if they continue to plan investments based on higher oil prices, the misallocation of capital continues. Also, dividends would likely need to be cut. In that case, there is still downside, despite sharp underperformance already."

With OPEC pumping out more production than it was even a year ago, the anticipated rebalancing of the markets may not happen in the second half of this year as many had anticipated. It's more likely to be in the last half of 2016.

"Oil futures have started to reflect this," analysts said. "Over the last few weeks, the back-end of the forward curve has fallen materially." Equities also appear to be pricing these factors in. At this point in the cycle in 1986, equities had begun to recover. The oil majors have now spent eight months yielding more than 1.8-times the market's yield, compared to only two months in total in 1986, Rats said.

"If oil prices follow the path suggested by the forward curve, and essentially remain range-bound around levels seen in the last two to three months, this downturn would be more severe than that in 1986. As there was no sharp downturn in the 15 years before that, the current downturn could be the worst of the last 45-plus years."

If that were to be the case, analysts said nothing in their experience would be a guide to the next phases of the cycle, and no history exists for such a downturn.

However, forecasting that the industry cannot rebalance costs with prices "would be a bet against history." For example, costs and capex are improving and industry is resetting the cost base quickly, following the 1986 precedent.

In late 1986, a modest recovery in oil prices began, despite 20-30% excess capacity, Rats noted. Today spare capacity is 2-3%.

"At the same time, demand is accelerating and capacity growth is slowing down severely: the industry has shelved 1,100-plus oil rigs globally, shrunk its workforce by 70,000-plus people, and canceled investments worth $130 billion for this year alone. We expect the oil market and the industry to rebalance, and the valuation upside would be large in that case. However, the timing of this has become more uncertain."

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