The final three months of 2007 ended on an up note for some of the largest North American natural gas producers, with higher earnings, higher cash flow and a slight bump in expected output, despite the "unmerited bearish concern for U.S. gas supply" created by the Independence Hub in the Gulf of Mexico (GOM), the Rockies Express Pipeline (REX) and liquefied natural gas (LNG) imports, energy analysts said Friday.
The 24 exploration and production companies (E&P) covered by SunTrust Robinson Humphrey/the Gerdes Group (STRH) should report 39% higher earnings per share (EPS) and 26% higher cash flow per share (CFPS) in 4Q2007 from 4Q2006, according to energy analysts John Gerdes and Michael Dane.
STRH's E&P coverage includes some of the largest independents operating in North America, and combined, they are 82% weighted to natural gas. Among them are Anadarko Petroleum Corp., ATP Oil & Gas Corp., Chesapeake Energy Corp., EOG Resources Corp., Southwestern Energy Corp., Ultra Petroleum Corp. and XTO Energy Corp.
Overall, the North American E&P's EPS in 4Q2007 "should rise 24%, while 4Q2007 CFPS should increase 23%," the analysts wrote. "Oil prices were 51% higher y/y [year-over-year], while natural gas prices were 6% higher than the year-ago quarter; production is estimated to have been 7% above the year-ago quarter. The strong y/y increase in 4Q2007 EPS/CFPS is largely a reflection of a more robust commodity price environment in conjunction with higher production, partly offset by 7% higher per unit operating/overhead expense."
Partially offsetting the strong quarterly earnings growth was 5% higher y/y noncash depreciation, depletion and amortization expenses, the analysts noted.
For the full year, STRH is forecasting that 2007 EPS for the E&Ps will decline 6%. Cash flow, however, "should have increased 10%," primarily because of 15% higher production growth that was partly offset by 6% higher operating and overhead costs.
Gerdes and Dane also expect to see a 1% increase in 4Q2007 production above the midpoint of company guidance.
"In 4Q2007, production related to our E&P coverage should have been 6% higher sequentially [from 3Q2007] and 7% higher y/y," they wrote. "Full-year '07 production is estimated to have increased 15%."
The STRH analysts recommend buying gas-weighted E&P shares "on weakness," and lower exposure to oil-weighted E&P shares. Some of their "favorite" E&P names from their coverage group include ATP, Chesapeake, EOG, Rosetta Resources and Unit Corp. They upgraded St. Mary Land & Exploration to "buy" because of an increase in its oil price forecast and an expectation that its 4Q2007 production will be 2% above the high end of company guidance. Goodrich Petroleum Corp. also was upgraded to "buy" based on its share price depreciation.
E&P share prices, said the analysts, reflect an estimate of $75/bbl for oil and an $8/Mcf gas price, prices that would "deliver market return on capital."
"U.S. gas-directed drilling activity is expected to remain relatively stable the first half of the year, increase modestly the second half of the year, and average 1,530 rigs in '08 assuming $8-$8.25 average gas price environment," wrote Gerdes. "Canadian gas-directed drilling activity should remain anemic this year (10-15% lower y/y) as Canadian gas producer cash margins remain 30% weaker than U.S. counterparts." STRH's E&P coverage portfolio is about 40% commodity price hedged through the end of 2008.
Holding to a forecast they made earlier this month, Gerdes and Dane said, "Given the cost environment, a 4% increase in '08 U.S. drilling activity, and the expectation that the E&P sector is comfortable budgeting 10-15% free cash flow negative, equates to an $8-8.25 gas price in '08" (see NGI, Jan.14).
"In an $8-8.25 Nymex [New York Mercantile Exchange] gas price environment, Canadian gas-directed drilling should decline an additional 10-15% in '08 after falling 42% in '07," they said. "Notably, natural gas prices in Canadian dollar terms have declined 20% since early '05 and correspondingly Canadian gas producer cash margins are roughly 30% weaker than their U.S. counterparts."
The STRH gas supply outlook generally assumes "roughly flat industrial gas demand. In '08, our gas supply outlook anticipates supply available for a modest increase in industrial gas demand."
The impact on supply and demand brought on by the deepwater Independence Hub, REX and LNG gas imports is overstated, said Gerdes and Dane. Beyond the growth in U.S. onshore natural gas supply and elevated gas storage, they said that three supply factors continue to weigh on the outlook for U.S. natural gas prices: approximately 1 Bcf/d of incremental deepwater Gulf of Mexico (GOM) gas supply related to the Independence Hub, the production impact of the 1.8 Bcf/d REX entering service, and the "robust" outlook for LNG imports.
Independence Hub "should stabilize GOM gas production this year" after declining 0.4 Bcf/d in 2007, the analysts wrote. However, REX is "likely to have a minimal near-term impact on Rocky Mountain gas production. Weakness in Wyoming drilling and convergence, with the onset of the heating-season, in Rockies/Nymex gas prices to reflect just the transportation difference, suggests there is minimal constrained production capacity in the Rockies."
Finally, U.S. LNG imports "should struggle to average 3+ Bcf/d in '08. Our current optimistic '08 U.S. LNG import expectation of 3.1 Bcf/d reflects 0.8 Bcf/d of y/y growth and is largely attributable to late-'07 liquefaction start-ups in Equatorial Guinea/Norway. Yet, continued erosion in '08 Pacific Basin liquefaction due to declining Indonesian output (Badak, Arun) and robust growth in Far East LNG demand imply the likelihood of an increased percentage of Atlantic Basin LNG cargoes migrating to the Far East in '08." These factors may lead to U.S. LNG imports only averaging 2.5-3.0 Bcf/d this year, they said.
"Given the cost environment and expectation that the E&P sector is comfortable budgeting 10-15% free cash flow negative, an $8-8.25 average gas price appears necessary to provide the financial incentive to modestly increase U.S. drilling activity and maintain gas market equilibrium in '08," said the analysts. "In '09, to provide the financial incentive to further increase North American drilling activity 10% to maintain market equilibrium requires a +$9 gas price."
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