Energy analysts with FBR Capital Markets have raised their forward natural gas price forecast in the second half of 2011 to $5.50/Mcf from $4.50.

"We believe that current operating margins are insufficient to 'incent' the required level of shale gas investment needed to balance the market beyond 2011," wrote analysts Rehan Rashid and Saurabh Lele. "As such, either cost structure needs to adjust materially lower or natural gas prices need to go higher for margins to become investable."

In the first six months of 2011, the analysts believe gas prices will average $4.50/Mcf. Earlier this year the energy team had forecast gas prices to average $4.41/Mcf in 2011, with prices in 1Q2011 averaging $5.12.

For crude oil, the forecast is "in general agreement with the New York Mercantile Exchange futures price curve, the strength of which we believe reflects the lack of material new long-term supply sources, rebounding demand, outlook for the U.S. dollar and geopolitical risk."

Oilfield service costs for exploration and production (E&P) companies aren't expected to drop in the near term, said the analysts, which means "natural gas price increases will have to provide the margin improvement."

Natural gas liquids-related drilling is forecast to "remain strong and exert continued upward pressure on service costs over the foreseeable future. In other words, service cost increases have sustainably manifested themselves into the E&P company cost structure."

For example, in the Haynesville Shale, considered "the marginal shale with scale potential," a $5.50/Mcf gas price is required to earn enough of an economic rate of return -- a 30% project-level pre-tax internal rate of return -- to be a "substantial" part of the supply picture.

Gas supply growth in the first six months of 2011 still is expected to be driven by "noneconomic issues" such as held by production drilling and clearing the backlog of drilled but uncompleted wells, said Rashid and his colleague.

"We observe that Haynesville and Fayetteville assets show the greatest sensitivity to gas price changes. For Haynesville drilling returns to compete with liquids drilling returns, gas prices would have to average more than $7.00/Mcf. As such, even with a rebound in gas prices to the $5.50/Mcf level, we do not envision a massive swing back to drilling for gas from oil."

On the gas demand side, electric generation, industrial demand and coal prices "have been stronger than our previous estimates," said the analysts. FBR Capital's outlook assumes 2.5% gross domestic production growth, normal weather and no material increase in demand from coal-fired generation shutdowns or consumption changes, such as a switch to electric or gas-powered vehicles.

Drilling in liquids-weighted plays and oil shales, said the duo, should be the focus in 2011, especially in the Permian, Niobrara and Eagle Ford shales.

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