A material increase in North American drilling activity may not be achieved until New York Mercantile Exchange (Nymex) natural gas futures prices approach $9/MMBtu, but high storage levels, increasing liquefied natural gas (LNG) imports and a lack of extreme heat could, in fact, put the chill on prices, energy analysts said in separate reports Monday.
In a note to clients, analysts John Gerdes and Michael Dane of SunTrust Robinson Humphrey/the Gerdes Group (STRH) wrote that a consensus among investors appears to indicate that an $8/MMBtu gas price environment would be enough to markedly accelerate North American drilling.
However, even if gas prices rose to $9/MMBtu in 2008, the industry would only be at "free cash flow equilibrium," they said.
Given that the energy industry "is currently about 20% free cash flow negative in an upper $7 gas price environment, we find it hard to envision a material increase in North American drilling activity until Nymex natural gas prices approach $9/MMBtu," said the STRH analysts.
The STRH analysts' 2008 price projections include a 5% inflation escalator and assume "essentially stable drilling activity relative to '07. However, it is our expectation that North American drilling activity should increase about 10% next year in a $9 gas price environment. Thus the E&P [exploration and production] industry would remain about 10% free cash flow negative in '08."
Canadian gas producer margins are 30% weaker than in the United States, and "even with a 10% reduction in aggregate oilfield service costs, it's not surprising Canadian drilling activity has fallen off a cliff," said Gerdes and Dane.
Since March, Canadian drilling activity has fallen 50% from a year ago, and it has remained 20% below last year's average since September 2006, said the STRH analysts. Because of the fall-off, "it remains debatable whether even a $9 Nymex gas price is sufficient to generate a significant increase in Canadian gas-directed drilling activity."
In the last half of 2007, STRH is forecasting an improvement in U.S. drilling if gas prices rise.
"As the industry is approximately 20% free cash flow negative in a $7.50-8 gas price environment, it's not surprising that $7.50-8 gas prices this year have yet to provide an impetus to materially increase U.S. drilling activity," wrote Gerdes and Dane. "Accordingly, it seems reasonable to not anticipate an approximate 10% average increase in U.S. drilling activity next year (1,475 gas rigs '07 to 1,600 gas rigs '08) without at least a corresponding increase in gas prices."
Gerdes and Dane noted that since 2004, operating and overhead expenses have jumped nearly $2/Mcfe, while unleveraged cash expenses have grown about $0.75/Mcfe. "Thus, cost normalized, the $6.14/Mcf average gas price in '04 equates to almost a $9 gas price environment today."
Taking another tack, Stephen Smith Energy Associates noted that a lot things are weighing on any advance in gas prices. In its research, the energy firm noted that the 14-week period ending July 6 is expected to record cooling degree days (CDD) that are 13% above regionally weighted CDD norms for the period, compared with the corresponding 14 weeks of 2006 when CDDs were 20% above regional norms.
"The next storage effect of this year's 13% over CDD norms for the last 14 weeks is that the gas storage surplus-versus-10-year-norms has increased from 683 Bcf to an estimated 692 Bcf over this same period," Smith wrote.
Several factors combined to yield this "surprising effect," said Smith, but LNG imports "were by far the most dominant cause. The increased CDD-driven demand was more than offset by an unprecedented level of LNG imports," which measured 2.8 Bcf/d for the 14 weeks versus 2.05 Bcf/d for the same period of last year, with comparable levels of Canadian imports in both years.
"Four or five weeks of extreme heat beginning in mid-July could still reverse this downward drift of this market," Smith wrote. "It would take at least a replay of last year's July and August." Without a weather factor, "the gas-to-resid spread would favor $1.00-$1.50/MMBtu negative until hurricane risk becomes more visible."
Based on current indicators and assuming New York Harbor 1% resid prices of $8.25/MMBtu for late August, Smith said a likely August Henry Hub bidweek price will range between $6.75 and $8.50/MMBtu, "unusually wide because of peak hurricane/heat uncertainty."
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