Analysts Say Drilling Activity Tied to $3 Mark

Domestic gas production is expected to show an increase from the first quarter of about 0.5% and about 3.4% growth compared to the second quarter of last year, Salomon Smith Barney (SSB) said in a second quarter preview last week. However, SSB analysts warned that the pace of domestic drilling could slow significantly if gas prices drop below $3.

"I think if you get below $3 you could see a pullback in drilling activity," SSB analyst Michael Schmidt told NGI. At current price levels, "I think you might see a slight pullback, but unless it goes below $3 [on a sustained basis] it is not going to be significant."

Lehman Brothers' Thomas Driscoll said he also believes $3 is a key level. "Clearly there is risk to drilling activity levels here," Driscoll told NGI. "I think any response is going to be delayed. Probably the next three months to six months you will see only a minimal impact" from decreasing gas prices on rig activity. "The bigger risk is what happens beyond that once the companies run through their current prospect? Do you renew it [rig lease] or do you release it?

"In the short term, I think they [E&P gas companies] are going to stick to their guns and continue to drill, but I think if gas prices were to go to $3, and stay at $3, we would see companies make decisions that things are sub-par in terms of economic returns," Driscoll said.

Driscoll said he expects to see 0.75%-1% production growth from the first quarter. He pointed out that growth from the fourth quarter 2000 to the first quarter of this year was 0.9% after adjusting for gas liquids production.

According to SSB, spot wellhead gas prices averaged $4.14/MMBtu in the second quarter 2001 versus $3.52/MMBtu in the second quarter 2000 and $6.22 in the first quarter 2001. However, most E&P companies sell the majority of their domestic natural gas during bidweek, and bidweek gas prices averaged $4.78/MMBtu in the second quarter 2001 versus $3.43/MMBtu in the second quarter 2000 and $7.17/MMBtu in the first quarter 2001, according to SSB's data. "Thus, bidweek equivalent natural gas prices increased 40% year-over-year and dropped 33% sequentially," SSB said in its "Exploration and Production: Second Quarter Preview.

"Consequently, we expect the more natural-gas leveraged names, on average, to outperform their more oil-weighted counterparts with regard to year-over-year CFPS growth. Cash flow per share on the quarter for the analyst's coverage group is projected to be up, on average, 50% when compared to the second quarter 2000, however, it is expected to be down 25% from the record high first quarter 2001 level. SSB expects per-unit operating costs for its universe, excluding production taxes, in the second quarter to remain "relatively flat" with first quarter results, although costs are expected to moderate during the second half of 2001 due to lower fuel costs given the pullback in commodity prices. Lower commodity prices also are expected decrease severance and ad valorem taxes during the second quarter by nearly 25%, on average, from first quarter levels.

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