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Raymond James Sees More Modest Gas Output Declines, Supply Still Constrained

The quality of U.S. natural gas prospects continues to diminish, and organic decline rates continue to rise, which means that the U.S. gas supply picture "remains quite constrained," according to Raymond James analysts.

In a new report, analysts said the North American energy "thesis" remains centered on the underlying problem of falling U.S. natural gas production. "Much like in the 1970s, when oil production continued to fall, regardless of how many rigs were drilling, we think we are nearing (if not at) a similar crossroads in the U.S. gas supply picture. While supply declines in 2005 and 2006 should be less severe than those observed in 2004, we expect domestic gas production levels to continue trending down."

Short-term gas prices and oil/gas price ratios should continue to be volatile, said analysts, but if oil prices remain near the $50/bbl level, "this would imply fair value for gas around $8/Mcf."

Raymond James' 1Q2005 survey of publicly traded oil and natural gas companies found a 1.3% year-over-year U.S. gas production decline, even though there was a 40%-plus increase in the gas rig count in the past 24 months.

Production was slightly up 0.2% sequentially over 4Q2004, which was credited to the end of Gulf of Mexico shut-ins from last September's Hurricane Ivan. Analysts said the latest results suggest that the recent decline rates in U.S. gas production may be moderating, but "we still think that production will continue to decline for the foreseeable future...contrary to what many of the gas bears have been suggesting over the past year."

Raymond James noted that the Energy Information Administration (EIA) shows a full-year 2004 production decline of 1.1% from 2003 for the entire industry. "This is much more believable than EIA data showing a production rise in 2003." Raymond James' surveys cover about 50% of U.S. gas production, and "if this is in decline, expecting growth from the small, mostly privately held producers outside our survey does not seem feasible."

More important, said analysts, majors and natural gas utilities "continue to show the biggest decline in gas production...down 6.2% versus last year. This is important since 1) the majors and utilities represent a large proportion of U.S. gas supply (roughly 22%) and 2%) drilling activity in this group has been essentially flat since the start of 2003. This indicates that further production declines lie ahead for this group."

Raymond James' numbers also indicate that "the independents are driving drilling activity increases, with only modest production response from the group to show for it. Specifically, the public independents have been responsible for putting an additional 39 gas rigs to work (a 12% increase), when 1Q2005 grew only 2.7% year-over-year and actually declined 0.5% on a sequential basis (compared to the 4Q sequential increase of 0.9%).

"Even though these results seem mediocre compared to the independents' massive level of investment, it is important to note that at current gas prices, these companies are making excellent returns on almost every prospect they drill. As a group, however, they have not been able to 'move the needle' on U.S. gas supply."

Raymond James' survey only covers 50% of total U.S. gas production, and the results are "not necessarily reflective of the other half -- which largely consists of smaller, mostly privately held, E&P companies. Given the vast number of these small players, it is impossible to get an accurate assessment of what their production is doing.

"However...growth in gas rigs among companies outside our survey has lagged the independents included in the survey over the past 12 months. This realization, along with the fact that drilling prospect quality among smaller, private companies is almost certainly worse than that of larger public companies, leads us to conclude that their 1Q production decline on a year-over-year basis, between 0% and 2%."

With no "significant" near-term catalysts to alter the declining gas supply picture, except for seasonally mild weather demand, price rationing "remains the only viable option to balance the gas markets," said analysts.

The 12-month futures strip has been above $6/Mcf since September, reflecting a tight supply environment, said Raymond James. "This is particularly impressive given the 6% warmer-than-normal winter season. Persistently, though, the equity markets (and most energy analysts) have yet to accept this reality. Although First Call consensus for 2005 gas prices has increased from $4/Mcf to $6.40/Mcf in the past 12 months, the current $7.15 price of the 12-month strip is still over 10% higher than consensus expectations."

In another opinion, Mississippi-based Stephen Smith Energy Associates said that the seasonal storage "targets" are 200-250 Bcf higher than historical norms, which would indicate that the summer outlook for gas prices "will depend mainly on the severity of summer heat and whether or not WTI [West Texas Intermediate] continues its recent trend decline (closed at $48.67/bbl on May 13)."

Based on weather assumptions and normal weather thereafter, Smith's estimated range for the Henry Hub July bidweek price is $6-6.50/MMBtu, which assumes a $45-52 WTI trading range between now and June 30.

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