Several indicators in January pointed to a pullback in 2007 natural gas drilling levels, which drove some prognosticators to reduce their drilling activity forecast and lower their expectations. However, the late arrival of cold weather has since driven gas prices higher, and rig permits have begun to rebound, leading Raymond James & Associates to conclude there will be an uptick in drilling activity by midyear that will carry well into 2008.

Analysts J. Marshall Adkins and James M. Rollyson on Monday raised their 2007 average rig forecast 12% from 1,600 rigs to 1,785 rigs (up 8% over 2006).

"Given the short-term sloppiness, there could still be some minor downward revisions to the earnings estimates of the drillers, but we think the current valuations (of mid-to-upper-single-digit profit-to-earnings multiples) already account for this. Hence, while we might be early, we believe that the risk/reward ratio for patient, longer-term investors has improved dramatically."

Early in the year, Raymond James analysts cut their 2007 gas price forecast to $7.50/Mcf because of the mild start to the winter season. As spot gas prices and the futures strip fell in late 2006, the analysts noted a 40% decline in the number of rig permits and a corresponding reduction in leading edge land rig dayrates. The decline in prices and rig permits led them to reduce this year's drilling activity forecast by 10%.

"Specifically, we estimated that, in the first half of 2007, the Baker Hughes rig count would decline by 10%, from a peak of around 1,700 rigs to a low of 1,550 rigs around midyear (averaging down 3% to 1,600 rigs for full year 2007)," said Adkins and Rollyson.

The analysts said publicly held exploration and production companies had generally indicated early in the year they would increase their spending, but "our channel checks suggested that the smaller, private 'checkbook' operators were scaling back activity levels -- in check with lower natural gas prices." As a result, they cut the activity outlook to reflect a 10% peak-to-trough reduction in drilling that would bottom around midyear. The cut also corresponded to a 3-4% reduction over 2006 levels. It all made sense at the time."

However, "a lot has changed over the past four months," the analysts noted. "The onslaught of cold weather beginning in mid-January caused natural gas prices (and more importantly the 12-month futures strip) to strengthen significantly. Rig permits have since bounced back as a result of a stronger gas outlook, and the Baker [Hughes] rig count has remained steady. Accordingly, it would appear that our activity forecast was overly pessimistic."

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