Natural gas prices are weak and will remain that way into 2011 because of abundant supplies and weak demand, Merrill Lynch, the investment banking arm of Bank of America Merrill Lynch (BAML), said Tuesday. Analysts slashed their forecast for U.S. prices in the final three months of 2010 by 16% and revised their outlook for gas prices for 2011 downward by 17%.
"We expect another weak gas market in 2011, with record production depressing prices," Merrill analysts said. "Low natural gas prices are likely required for an extended period of time in order to constrain horizontal gas drilling and encourage demand."
The domestic gas rig count totaled 985 last Friday, up 42% from a year earlier, according to Baker Hughes Inc. The horizontal rig count rose to a record 895.
Merrill's forecast gas price in 4Q2010 now is set at $4.80/MMBtu, down from an earlier prediction of $5.60. The 2011 forecast was reduced to $5.00/MMBtu from $6.00.
Gas prices have support at current levels even though U.S. gas forward prices "have gone into a tailspin," noted the Merrill team. Forward prices are "unlikely" to dip below $3/MMBtu as they did in 2009 because more "robust baseload power demand and continued hot temperatures" point toward a lower end-of-season working gas storage level.
"The 12-month forward strip now prices at $4.50/MMBtu, down from $5.15/MMBtu at the start of August and $6.20/MMBtu at the start of the year. In fact, every single strip out to 2015 now sits below $6. Against our expectations, even very long-dated U.S. natural gas prices from 2013 onwards sold off," analysts noted. Since last year, noted the Merrill analysts, drilling in shale plays "has displayed virtually no sensitivity to gas prices at all." BAML is projecting U.S. gas output to grow by 0.9 Bcf/d in 2010 and 1.7 Bcf/d in 2011.
Analysts noted that production in the Haynesville, Marcellus and Eagle Ford shales, as well as the Granite Wash play, have skyrocketed since late 2009. "These plays are proving to be extremely dynamic, benefiting from continued improvements in gas rig efficiency and well productivity. In the Haynesville alone, production is up about 2.4 Bcf/d this year relative to last."
The number of producing wells has risen sharply over the past months, noted the Merrill team, "and the inventory of permitted wells waiting on completion, [hydraulic] fracturing or other operations is large. Permitted wells that are not yet drilling are also back at a record high. Shale gas is still leading the way. The summer heat has given gas demand an "immense boost," but "assuming a return to more normal temperatures, BAML believes that the balance next year could turn out to be worse than this year."
Gas price "inelasticity partly highlights the lower break-even costs of nonconventional gas plays," said the Merrill analysts. "Break-even economics in some shale plays may be as low as $3/MMBtu. Moreover, a shift of focus within the industry to condensate and NGL [natural gas liquids] plays like the Eagle Ford in South Texas have also been driving the drilling recovery as liquid production boosts revenues. Furthermore, production costs have gone down due to efficiency gains." With "strong demand" for high-end horizontal gas rigs, "even if the rig count declines, these highly efficient rigs which reduce drilling times are likely to continue to work."
To exacerbate the abundance of U.S. gas supplies, Canadian drilling now appears to be going through a recovery, noted the Merrill team. Canadian gas exports to the United States continue to shrink, but "they are doing so at a lower pace amid signs that the supply decline could slowly come to an end." Like the United States, "the recovery is geared to deep and horizontal wells tapping shale or other unconventional reserves, especially in British Columbia."
However, liquefied natural gas imports "will unlikely be an issue," and will average marginally above this year's level, the Merrill analysis said.
Industrial gas demand "is likely to pick up on lower prices and major gas consumers like aluminum producers will shift back" to natural gas, said analysts. "There is enormous pent-up demand from the electricity sector as power producers will be building more natural gas-fired power generation plants in the coming years. Combined, this should put upside pressure on U.S. natural gas demand, and eventually U.S. natural gas prices in the medium term."
Analysts with SunTrust Robinson Humphrey/the Gerdes Group (STRH) agreed Wednesday that "gas prices do not appear poised to pop. With gas-directed drilling activity at 985 rigs, the industry is 30% free cash flow negative this year. A similar outspending of cash flow next year would likely lead to a $4.50-plus price, only modestly above current prices and partly due to lower expected cash flow from hedges.
"On the other hand, prices should not drop much, either," said STRH analysts. "Coal-to-gas fuel switching should place a floor on gas prices near current levels as we expect an incremental 2-3 Bcf/d of gas-fired power demand."
Meanwhile, Barclays Capital analysts said Tuesday that "at just short of 1,000 rigs, with a focus on highly prolific shale wells, the rig count should lead to sequential growth in U.S. production unless rigs are taken out of service."
Barclays analysts expect the rig count to drop in 4Q2010 "but there are various nonprice-related factors to watch for in coming months that will likely determine the amount of drilling ahead."
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