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2Q Domestic Production Slips 1.2%, Based on Surveys by Raymond James, UBS

Despite a 30% increase in gas-directed drilling in the United States over the last two years, quarterly production statistics from public financial reports show domestic production is still declining, analysts at Raymond James & Associates and UBS said this week. Both found second quarter domestic gas production down 1.2% from levels at the end of the second quarter of 2004 based on separate E&P surveys.

"What does this mean to U.S. natural gas prices?" asked Raymond James' J. Marshall Adkins. "As before, we see no significant near-term catalysts to alter the declining gas supply picture... That means that outside of seasonally mild weather demand, price rationing remains the only viable option to balance gas markets.

"With the 12-month futures strip staying above $6.00/MMBtu since last September, and in recent weeks approaching the $9 level we believe commodity market pricing reflects this tight supply environment."

UBS analyst William A. Featherston agreed that the industry's "inability to grow production is supportive of stronger longer term prices." However, the current Wall Street consensus forecast for 2006 prices is only $6.80 compared to a 12-month strip of futures prices on the New York Mercantile Exchange of $9.510 at the end of last week. That means there's a $2.71/MMBtu difference between what the market expects gas prices to average next year and what Wall Street is expecting.

UBS' survey even showed that domestic production was down both year to year and sequentially compared to levels during the first quarter. UBS data indicated gas production was down 0.2% from 1Q2005. Raymond James' survey showed production rose 0.7% sequentially compared to the first quarter, indicating that the domestic production slide may be moderating.

"Despite the moderating trend, however, we still think that production will continue to decline modestly for the foreseeable future," said Adkins. "The EIA is recognizing this as well, following multiple downward revisions, with its current data for full-year 2004 now showing a year-over-year production decline of 1.1% for the entire industry. This is much more believable than EIA data showing a production rise in 2003."

Raymond James analysts say the majors and utilities with E&P have been leading the declines, reporting a 5% drop in the second quarter from 2Q2004. Meanwhile, the independents have been leading the drilling increases with "only modest production response from the group to show for it," according to analysts at Raymond James.

Adkins said that the large organic production increases from Chesapeake Energy, EnCana, EOG and Ultra prevented the group as a whole exiting the quarter with a slight production drop rather than an increase.

"The industry is now at virtually 100% utilization of onshore gas rigs, and gains in drilling efficiencies have also been significant over the past two years," said Adkins. "Going forward, constraints on rig availability are likely to become more noticeable and gains in efficiencies should slow. Meanwhile the quality of the prospects that are being drilled is diminishing and organic decline rates for the industry continue to rise. This means that the U.S. gas supply picture remains quite constrained."

Adkins said that while the production declines of 2005 and 2006 should be less severe than those in 2004, production will continue to trend down despite the massive drilling effort by the industry. As a result, he expects that once the current gas storage surplus is worked off, natural gas prices will return to a 6:1 Btu parity with oil prices, meaning that when oil is at $60/bbl, natural gas should be about $10/MMBtu.

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