Higher oil and natural gas prices have resulted in robust revenue for exploration and production (E&P) companies, but the accompanying surge in service costs has dampened the financial windfall -- and an $8/Mcf gas price may be required to deliver a market return on capital going forward, according to energy analysts.

"E&P capital intensity of $4.70/Mcfe and unlevered cash expenses of $2.20/Mcf equate to a current E&P cost structure of $6.90/Mcfe," said John Gerdes and Michael Dane of SunTrust Robinson Humphrey/the Gerdes Group (STRH). Using an assumption that gas price realizations reflect an average 50 cent/Mcfe discount to New York Mercantile Exchange (Nymex) Henry Hub, "the numbers imply a Nymex-normalized cost structure of $7.40/Mcf, which suggests a Nymex price of at least $8/Mcf would be required to deliver to investors a market return."

The STRH energy analysts recently surveyed 39 producers that account for about two-thirds of U.S. gas production. Gerdes and his team reported that U.S. onshore gas production in 3Q2007 rose 1.1% sequentially from 2Q2007 and increased by 3.5% from 3Q2006 (see NGI, Nov. 19). Although the numbers vary as to how much U.S. gas production is growing, other energy analysts agree that it is increasing (see related story).

However, the STRH spending survey indicated that the modest gains in output run parallel to cost escalations.

According to STRH, unlevered cash expenses in 2007 are expected to average about $2.20/Mcfe of production, which is almost 5% higher than a year ago. Total unlevered expenses, which include depletion, depreciation and amortization are projected to average about $5.20/Mcfe this year, which is about 10% higher than in 2006.

If, as they project, E&P margins expand 9-10% next year in an $8.25 gas and $70 oil price environment, it could encourage "a minor increase in U.S. drilling activity," said Gerdes and Dane. However, even at the higher gas price and the steady oil prices, a level of drilling activity comparable to 2007 and no capital cost inflation, "the E&P industry appears likely to remain 10%-plus free cash flow negative."

And this lack of E&P free cash flow "should continue to present a constraint to increasing U.S. gas-directed drilling activity," said the analysts.

"To balance U.S. gas market fundamentals in '08, our analysis suggests U.S. gas drilling activity needs to increase 5% and optimistically assumes Canadian gas-directed drilling activity stabilizes at '07 levels. Notably, a 5% increase in U.S. drilling activity and corresponding increase in capital spending implies the E&P industry would remain 15-20% free cash flow negative in '08. Moreover, given a 5% increase in U.S. drilling activity, our no capital cost inflation expectation may prove optimistic."

Moody's Investors Service also reported that rising costs are limiting the "positive impact" of historically high oil and gas prices for independents.

"Costs are unlikely to decline in the near term and will continue to pressure margins, reduce free cash flow and increase leverage for the E&Ps," Moody's said. "Although the rating outlook is stable, there is more downside risk right now for ratings than upside potential."

Moody's noted that investment-grade producers "for the most part, have managed their cash flow and weathered increasing costs more effectively than their lower-rated peers. For high-yield companies, cash flow fell 15%. Investment-grade companies are expected to continue generating free cash flow overall. For individual companies, outspending cash flow typically indicates poorer credit quality."

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