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Drop in Drilling Could Stabilize Market, Analysts Say

October 20, 2008
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A roughly 20% drop in domestic drilling activity seems necessary to align exploration and production (E&P) industry cash generation and capital spending, according to an analysis by SunTrust Robinson Humphrey/the Gerdes Group (STRH).

Reducing the U.S. gas rig count to 1,250 in 2009 could slow growth in domestic gas production sufficiently to reestablish market equilibrium -- to about a third of the growth experienced this year -- even when including a 7.5% increase in well productivity in the equation. Shale resource plays will drive onshore well/rig productivity up by 15% this year, according to STRH. A 2% increase in well/rig productivity in 2007 accelerated by 15% this year, driven by shale resource plays, they said.

In an $8 gas price environment and assuming 2008 drilling levels (1,500 gas rigs), the E&P sector would be 10-20% free cash flow negative, the analysts said.

"This meaningful level of negative free cash flow, reinforced by acute credit market concerns, suggests the E&P sector to reduce drilling activity at least 20% to budget within cash generation," they said. "Notably, anecdotal evidence to date largely supports this view."

Solid growth in 2009 in power generation demand is largely a consequence of mild 2008 summer weather, hurricane-disrupted power generation this year and lower natural gas prices next year, they said.

Canadian gas-directed drilling activity declined 42% last year, reflecting the lower selling price for Canadian gas and a stronger Canadian dollar. As a consequence, Canadian gas producer cash margins are about 30% below their U.S. counterparts, according to STRH.

Last week the Energy Information Administration reported that 79 Bcf was injected into underground inventories for the week, increasing storage levels to 3,277 Bcf, despite approximately 36.6% of the Gulf of Mexico's production remaining shut in from hurricanes Gustav and Ike. STRH's Nov. 1 gas storage expectation is 3,500 Bfc, which the analysts said is "modestly elevated in an historic context, [but] is at the necessary level of gas in storage given the growth and heightened seasonal volatility of gas-fired power generation demand."

In August STRH said North American E&P companies' cost structures and share prices suggested that natural gas prices need to be more than $8/Mcf and oil has to be more than $70/bbl to deliver a market return on equity capital. At that time natural gas futures were trading below $8/Mcf; at the start of trading Friday, futures were expected to begin the day at $6.83.

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