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Barclays: Credit Market, Not Prices, May Impact '09 Gas Drilling

The tight credit environment could prove to be bigger concern for natural gas drilling in 2009 than the sharp fall-off of gas prices over the past few months, Barclays Capital energy analysts said last week.

Although gas prices are substantially below this past summer's highs, forward gas prices remain above last year's levels and aren't a threat to drilling economics at this time, said a team of Barclays analysts led by George Hopley. "However, although not currently evidenced by a widespread pullback in capital spending, the tightness in the credit environment could prove to be a more immediate concern than prices for drilling activity into 2009. A further drop in forward prices, however, would add to the effect of tighter credit markets by curtailing drilling."

Domestic gas production growth has gained momentum, and the rig count would have to drop to below 1,350 rigs to reverse this trend, wrote Hopley and his team. Two regions to watch for signs of a reversal in gas drilling are Texas and the Rocky Mountains, but both show no letup for now, wrote the Barclays team.

If forward natural gas prices do not yet indicate a cutback in gas drilling, "in our view, challenging capital markets are the most immediate factor that could slow the pace of drilling," said Hopley and his team. "The extended turmoil in the U.S. financial markets and the collapse and transformation of several major financial institutions have left deep scars in the overall credit environment. As default rates increase across multiple sectors, lenders are paring their risk appetites, and, as a result, the supply of debt has dried up."

One particularly relevant area to watch for the gas markets is how the bond market goes, noted the Barclays team. High-yield bonds are the source of funding for many producers' drilling programs, they noted. "Year-to-date, high-yield issuance totals approximately $70 billion, down almost 50% from 2007 levels. Issuers that can get deals done will pay notably higher interest costs relative to one year prior -- with coupons likely to be 9-10%, versus 7-8% one year ago..."

It's still too early to judge what impact the credit crunch may have on drilling programs going forward, the Barclays analysts wrote. "We will look for further announcements of capital spending budget reductions over the next few months to gauge this trend. Stated otherwise, given the current price environment, the ability of producers to finance spending could prove a more immediate concern than prices for drilling activity in 2009."

A bigger impact on drilling, and one that could ultimately pull the rig count much lower, would be a further pullback in gas prices, they noted. The all-in, break-even cost of gas production "spans a very wide range, and producers are not uniform in their approach to drilling decisions," but "we believe a meaningful chunk of rigs would be lost if the 12-month forward gas price fell sustainably below the $7.50 mark. At forward prices sustainably below $7, we believe enough rigs could be lost to ultimately halt U.S. supply growth."

Producers, noted the Barclays analysts, "cannot turn their drilling programs around on a dime. Thus, if a combination of credit constraints and an additional drop in forward prices further undermined the economics of drilling, we would expect it would take six-eight months to start affecting supply."

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