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Analysts: Drilling Impervious to Coming Gas Price Slide

July 28, 2008
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The recent pullback in natural gas prices is just the beginning of a downward slide that could continue for the next six months, according to analysts at Raymond James & Associates Inc.

"As we have detailed numerous times, a further weakening of gas prices should be driven by a sharp increase in U.S. natural gas production, easier y/y [year-over-year] liquefied natural gas (LNG) comparisons (starting in September) and easy weather comparisons (starting in August)," the analysts wrote in a research note last Monday. "Of course our bearish outlook also assumes 10-year average weather and no hurricanes."

While predicting a further pullback in gas prices, the Raymond James analysts noted that they don't expect this to affect drilling activity for a number of reasons. For one, exploration and production companies have hedged production at "extremely attractive levels." Also, higher coal prices have raised the floor under gas prices to more than $7/Mcf. Growing production from unconventional resource plays appears to be economic at or below Raymond James' $7.50/Mcfe 2009 price estimate. Finally, oil-directed drilling accounts for more than 20% of total activity in recent months.

"Additionally, recent rig permit data indicates that drilling will continue to rise in the near term with record permits issued in the past couple of months (up 16% year-over-year)," the analysts wrote.

With natural gas prices already down more than $3/MMBtu from the highs they reached at the beginning of the month, the time to switch from coal-fired to gas-fired generation may be approaching -- but is not here yet -- analysts at Barclays Capital wrote in a weekly report published last Tuesday.

"Most of the discussion under this new set of market prices centers on divining the level at which expensive coal generation will be pushed off the margin to be replaced by cheaper and very efficient gas plants," Barclays analysts said. "Important in this consideration will be how much capacity switch constitutes a material amount of incremental gas demand."

With recent New York Mercantile Exchange coal prices reaching a pause near $105/ton, the analysts calculated the "all in" power price from coal to be $70/MWh, while the equivalent gas price, delivered at $9.60/MMBtu was calculated to be $72/MWh. The calculation "might show on paper a nominal switch point, but we note that there are some asymmetric conditions for coal plant operators and gas plant operators," they said.

"For those utilities in competitive ISO [independent system operator] markets, the relative economics will be easy to discern by system operators through bidding, and the decision to switch off one coal plant and replace with a gas plant might be straightforward, given a large range of gas capacity in waiting. In non-ISO markets, the incentives to switch may be less apparent to a smaller fleet operator, with less availability of gas plants waiting to switch into dispatch. It may involve noneconomic considerations, including changing the grid topology, congestion and reliability issues. The short-term gains from switching plants might also be lost if the coal plant cools down, but then if called into dispatch again is unable to respond quickly.

"Thus, while prices start to converge, there may not be an immediate change in power plant behavior and prices may need to cross and stay there before demand starts to make an impact on the gas market fundamentals...The incentives begin to line up the faster gas prices go down, versus steady coal prices. However, there is still room to go before a new state of demand is reached."

Last month Barclays analysts said power generation reserve margins had been shrinking to the point that the industry should be thinking about new capacity, but prices were too low to cover new-build economics. Spark spreads aren't high enough to entice developers to build new gas-fired generation -- at least not yet -- they said.

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