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Decline Rates Give Rise to Bullishness, Say Raymond James Analysts

Much is said, and often, about how escalating decline rates have cast U.S. gas producers onto an ever-accelerating treadmill. In the latest "Stat of the Week" from Raymond James & Associates Inc., a trio of analysts points at decline rates with alarm and, of course, bullishness. "The treadmill is running too fast," the analysts say, while conceding that this view is a contrarian one in some quarters.

The analysts predict that for 2006 new production will lag declines by about 1.3 Bcf/d, and in 2007 the shortfall will be about 0.7 Bcf/d.

"Most investors with whom we have spoken recently believe gas supply will be up nicely (2% to 3%) in 2007, which will force U.S. gas drilling activity to slow and even roll over," write the Raymond James analysts. And last week SunTrust Robinson Humphrey/the Gerdes Group wrote that domestic U.S. gas output could rise 2% in 2006 (see Daily GPI, Nov. 22).

Not so, Raymond James is telling investors. The cruelty rendered by the modern drill bit is diminishing returns as reward for increased efforts and expertise on the part of producers.

"U.S. gas well decline rates continue to increase at an accelerated pace, as advanced completion technologies allow E&P companies to extract more gas from smaller pockets more quickly," writes Raymond James. "The most important question that most investors are NOT asking is, 'What effect will these increasing decline rates have on U.S. gas production?'"

Raymond James finds through analysis of Energy Information Administration (EIA) data and decline rate statistics from EOG Resources Inc. that a "substantial increase in drilling rigs" will be necessary to offset rising decline rates and declining production per new well.

"Although it is somewhat counterintuitive, the trend toward lower-quality reservoir rock that is typical of resource plays has also driven initial production rates per new well lower!"

Producers are drilling substantially more wells in lower-quality rock. Lower permeability shales give off less gas initially than highly permeable Gulf Coast sandstone, for instance. Further, the common practice of high-grading prospects means that over the life of a field, basin or county the prospect drilled tomorrow will almost always produce less than the one drilled yesterday, say the Raymond James analysts, who cite the Barnett Shale and Chesapeake Energy as examples.

The Barnett provides an ideal example of resource play production behavior. Since the beginning of 2002 the Barnett has seen a 360% increase in gas rig count while production over the same period has grown by 215% to nearly 2 Bcf/d. "More importantly, average first-year decline rates are around 65% in the Barnett," says Raymond James. "That means the rig count must continue to increase by 21% (or 32 rigs) in 2007 just to keep Barnett gas production flat."

As for Chesapeake, the most active U.S. driller and a large player on the resource/unconventional play stage, virtually every one of its major producing areas is seeing first-year decline rates greater than 50%, with the average closer to 65%.

When it comes to rig efficiency, the industry is holding its own. "As the difficulty and depth of wells has increased, improvements in hydraulic horsepower, drill bits, top drives, etc. have allowed the number of wells drilled per rig to stay relatively constant," the analysts write.

Based on their analysts, the analysts project that production will be down at the end of 2006 and in 2007 as well. For 2006, the production decline is estimated at 15.5 Bcf/d. Estimating a gas rig count of 1,375, a rig efficiency ratio of 23 yields a total of 31,625 wells drilled. Assuming no deterioration from 2005 first-year production levels (0.449 MMcf/d), total new production for 2006 will be 14.2 Bcf/d. The same exercise for 2007 yields a decline estimate of 15.6 Bcf/d, which overcomes new production estimated at 14.9 Bcf/d.

"Looking ahead to 2007 and beyond, we believe continued increases in unconventional drilling activity and improvements to completion technology should further exacerbate the problem and may in fact leave the gas market undersupplied," the analysts write. "Therefore, we believe an incremental increase in the rig count is a necessity, and current fears surrounding the overbuilding of drilling rigs are unwarranted."

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