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Outlook: Gas Producers' Success Proves No Guarantee

There's some truth in the old saying about having too much of a good thing. Just ask North American natural gas producers.

Exploration and production (E&P) companies last year continued to prove that they could not only find better ways to recover unconventional gas resources, but that they were good at finding new plays. It was less than a year ago that producers unveiled their discoveries in the Haynesville Shale and Horn River Basin. And it was just last year that new technologies allowed Barnett Shale output at existing wells to begin trending higher -- instead of lower.

New discoveries and the new technologies led producers to rapidly build positions in some of the promising gas basins from coast to coast. Their work was rewarded by summer, when gas prices in July climbed above $13/Mcf and company stock prices moved ever higher. The lemonade days of summer were quickly followed by the sour taste of fall, when collapsing financial markets stymied demand and prices tumbled. Now producers that had borrowed to build positions in the gas-rich regions can't lay down rigs fast enough.

Energy analysts generally have agreed about where gas prices are headed in 2009 -- and it's not up. A long list of energy analysts and consultants has forecast that prices won't move beyond $6/Mcf until late this year -- and more likely not until 2010. Wood Mackenzie's Jen Snyder, who heads the firm's North American gas research arm, is one of those consultants who sees a "prolonged period of significant weakness" for U.S. gas prices. The U.S. market, she said, should expect prices "in the range of $5 to $6/MMBtu" for as long as the next four to five years.

Wood Mackenzie and its peers are noting the obvious: North American gas production is strong and demand is weak. The jump in output could not have come at a worse time. The recession has pressured industrial demand, which in turn has led to a slowdown in gas drilling that is becoming more evident by the week. The U.S. gas rig count onshore for the week ending Jan. 2 fell to 1,206 from 1,285 reported in the previous week. Gas rigs have fallen 13% from a year ago, and the count is down 11% from early December.

"We are now in a position of significant potential oversupply brought about by the huge success experienced in the development of shale gas plays," said Snyder. "Most commentators are pointing toward prices settling at the marginal cost of the most expensive shale plays," but "we think this is a mistaken reading of the current and future environment. Simply stated, there is no requirement for the rapid near- to mid-term development of some of the more expensive or challenging shales such as the Marcellus or Horn River; the market can be adequately supplied without these volumes. We believe that there are sufficient volumes available at a development break-even price of $5.50/MMBtu or below for the market to balance."

Wood Mackenzie's forecast takes into account a decline in demand that could continue until late 2010. It also factored in new wind and coal-fired capacity coming online to serve power load and the "significant" drop in drilling activity because of lower prices. "We have also factored in the positive impact on break-even costs due to cost reductions associated with this drilling slowdown and continued optimization of drilling solutions at those plays that will continue to be aggressively developed," Snyder noted.

In addition, other "outside factors" haven't been taken into account by the market, she said. Wood Mackenzie's analysis suggests "significant import volumes" of liquefied natural gas (LNG) into North America over the next few years, even with the recent growth in unconventional gas.

"There are a number of reasons for this," Snyder said. "Existing offtake agreements for some suppliers make diversions from North America unlikely. In addition, other suppliers with flexible LNG will want to avoid jeopardizing long-term contract prices in Europe and Asia, through a further weakening of spot prices in these areas, and the Qataris in particular are likely to direct some of their new volumes to the U.S. market, where there are no long-term contract implications and a large and liquid market to absorb the volumes."

Wood Mackenzie's $5-6 gas price forecast could fall even lower in the near term, said Snyder.

"Our near-term forecast is predicated on a normal winter," she said. "While a severe winter could tighten up the market and provide some near-term support, equally a mild winter could exacerbate the current position of oversupply and lead to prices into the $4.00/MMBtu range in the near term. We have also assumed that gas demand benefits from a 1.5 Bcf/d switch from coal to gas-fired power generation. If this fails to materialize, due to collapsing coal prices, this would further add to short-term price weakness."

Stephen Richardson, an analyst at Morgan Stanley & Co. Inc., said the year-end gas rig count moved lower at a faster rate than analysts expected. And the decline in the horizontal rig rate may "address a concern of the bears that the rig count decline had been centered upon less productive vertical rigs." But the size of the decline, he noted, could have been helped by year-end contract expiries, which suggests that the pace in dropping rigs may moderate later this month.

"We continue to expect a 500-600 rig decline to drive flat production in '09 and address the near-term oversupply facing the market," Richardson said.

Other energy analysts, including Raymond James & Associates Inc. and Barclays Capital, think it will take a huge reduction of gas rigs to balance supply (see related story). Shut-ins are likely this summer, and look for "curtailment of at least the most marginal projects," said the Raymond James team.

Supply and demand data for October by the Energy Information Administration was obscured by post-hurricane recoveries, Richardson noted. A key industrial segment rose about 10% from September as refiners ramped up following the Gulf of Mexico storms. However, demand was 4% below the five-year average.

"Where do we stand? Strength in E&P equities may continue to be driven by broader market optimism, a potential bottoming in commodity price, particularly in crude where consensus expects OPEC cuts will improve balances, and supportive seasonal weather patterns," Richardson said. "Natural gas will continue to face challenging balances in the first quarter of 2009, particularly as weather [comparisons] become more challenging in February and March, and demand weakness looks likely to continue."

Historians note that between 1999 and 2000, gas prices rose from less than $3/Mcf to more than $9, and with that price jump, more than 600 drilling rigs were added in North America. An oversupply and a drop in demand at the end of 2001 in turn reversed prices, and for a period gas returned to trading below $2. Over the next six months almost 400 drilling rigs were idled.

Today it's more difficult to access the tight credit markets, which has added to the dilemma for drillers. Chesapeake Energy Corp., which long held the title as the leading U.S. gas driller, in late 2008 slashed $4.7 billion from its capital expenditure (capex) plans through 2010 and trimmed its drilling capex through 2010 by 31%.

Other gas-directed producers followed, and more have announced plans to operate within their cash flow until conditions improve. The cutbacks are flowing across the sector, and last week oilfield services giant Schlumberger Ltd. announced it would lay off close to 1,000, or 5%, of its North American workforce (see related story).

Less than 20 years ago natural gas was "hard to find and easy to produce," noted energy analyst David Pursell of Tudor, Pickering, Holt & Co. The unconventional plays have made gas "easy to find and hard to produce." One risk is traded for another, he noted. Producers earlier focused on geology and geophysics. Now, "it's much more of a completion and engineering game."

To flourish, gas producers somehow have to learn to adapt to a new paradigm, said Kaiser-Francis Oil Co. CEO H.G. "Buddy" Kleemeir. There are huge new gas deposits spread across North America that now have minimal geological risks but more engineering risks and continued volatile prices.

It's still learning to follow the simple rule of "prorationing by price," Kleemeir said. As prices fall, producers idle rigs. And those rigs, he said, will remain idle until prices recover.

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