Natural gas market fundamentals suggest that U.S. drilling activity could rise by only 2% this year but increase by 10% in 2009, according to an analysis by SunTrust Robinson Humphrey/the Gerdes Group (STRH).
Analysts John Gerdes and Michael Dane wrote in a note to clients that U.S. gas-directed drilling activity this year is likely to be constrained because of negative exploration and production (E&P) cash flow. Their analysis of U.S. drilling this year and in 2009 assumes that Canadian gas-directed activity will be 10% lower this year and also up by 10% in 2009.
"Notably, this trajectory of North American gas drilling activity and corresponding capital spending would imply the U.S. E&P industry remains +15% free cash flow negative," Gerdes and Dane wrote. STRH's E&P coverage portfolio of 25 producers has hedged on average about 45% of commodity price exposure. Of the E&Ps the analysts cover, Edge Petroleum Corp., Bill Barrett Corp. and Range Resources Corp. "have hedged over 70% of their anticipated '08 production," while Arena Resources, W&T Offshore and Unit Corp. have hedged less than 20% of this year's output. Other E&Ps covered by STRH include Anadarko Petroleum Corp., EOG Resources Inc., Chesapeake Energy Corp., Southwestern Energy Corp. and XTO Energy Corp.
In their view of the covered portfolio, E&P cost structures indicate that $8.50/Mcf gas prices would be required to deliver a market return on capital, wrote the duo. "Average E&P capital intensity of $4.75/Mcfe and unlevered cash expense structure of $2.35/Mcfe equate to an all-in E&P cost structure of $7.10/Mcfe."
As E&P gas price realizations generally reflect a $0.50/Mcfe discount to the Henry Hub, the New York Mercantile Exchange (Nymex)-normalized all-in cost structure would be $7.60/Mcfe, they wrote. "In the context of a $7.60/Mcfe Nymex-normalized cost structure, not surprisingly, our Market-Equity-Return valuation suggests a Nymex natural gas price of $8.50/Mcfe is required to deliver investors a market return on E&P shares."
In 4Q2007 STRH's E&P portfolio was 1.3% above the analysts' expectations in aggregate, but the portfolio also experienced higher-than-expected costs. Projected average 2008 unlevered cash expenses (overhead/operating expense) have since increased 2.8 points to 6.7% as a consequence of the final quarter's results, while E&P development capital intensity "remains on trend to increase almost 10% in '08 after increasing almost 25% year/year in '07," wrote the analysts. Since 4Q2006, "the escalation in E&P capital intensity has slowed to slightly less than the historic norm of 10% per annum."
The unlevered development cash cost structure of STRH's E&P coverage portfolio now is averaging around $6.50/Mcfe. Including exploration outlays, which generally comprise 10-15% of total capital outlays, the "true" cost intensity of the E&P coverage portfolio is about $7.10/Mcfe, said the analysts.
"Given E&P managers' desire to spend sufficient capital to organically grow their business +15%, the E&P sector, even in a low $8 gas price environment, is 10%+ free cash flow negative," wrote Gerdes and Dane. The median North American 2008 E&P capital intensity related to development is $4.30/Mcfe, "which is almost 10% above the '07 average. Grossing up the development capital intensity to account for exploration spending, which generally comprises 10-15% of total E&P capital outlays, equates to an all-in median E&P capital intensity of about $4.90/Mcfe." This year they expect unlevered cash expenses to average about $2.35/Mcfe of production, which would be almost 7% higher than last year.
"E&P cash margins should expand 12% in '08 assuming a conservative $8.20 gas/$80 oil price environment...while gross profit margins expand 24%," wrote the analysts. "Stronger margins should encourage an increase in U.S. drilling activity during the year reinforced by a further 9% increase in cash margins in '09 assuming $9 gas/$80 oil prices. Even in a $9 gas price environment, the E&P industry is modestly free cash flow negative."
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