Low natural gas prices failed to deter exploration and production (E&P) operators in 2010 and that's likely to be the scenario again this year, according to several energy analysts.
"At $4.00/Mcf gas in 2011, we think companies can and will fund development plans," said the E&P research team at Tudor, Pickering, Holt & Co. Inc. (TPH). "While positive from a liquidity standpoint, circular logic persists...More gas supply equals lower gas prices equals lower stock valuations."
The "supply/demand imbalance is a duration issue and gas prices will increase long-term to reflect the marginal costs of supply," said TPH analysts. "But the availability of funding (capital raises, bank revolvers, joint ventures, etc.) continues to push that recovery further out. Gas is an investable commodity longer-term but likely gets worse before it gets better."
Raymond James & Associates Inc. said E&P companies had "drilled right through $4.00/Mcf gas prices in 2009 and 2010, and we expect them to continue to do so in 2011" (see Daily GPI, Jan. 4). "Yes, activity will fall in some of the vertical and horizontal dry gas areas but we expect that these areas will only account for about a 10% reduction in overall U.S. gas drilling activity in 2011. If the U.S. gas rig count only falls 10%, U.S. gas production will continue to increase substantially into 2012."
TPH's E&P coverage universe is generating an estimated $78 billion in cash flow through 2011 while spending about $80 billion for capital expenditures. "However, the numbers are skewed by large caps. The small-mid cap group is outspending by $7 billion in 2011. Gassy small-mid caps are reinvesting 150% of 2011 cash flow while oil companies are reinvesting 180% of their cash flow. With 80% of the mid and small-cap companies within our coverage group outspending in 2011, these numbers shouldn't come as a big surprise."
However, the gassy companies "heading into a weak gas tape in 2011 are continuing to outspend," said the TPH team. The "facts remain...that companies aren't jamming on the breaks in front of an uncertain commodity environment."
In their review, analysts with BMO Capital Markets said the "high level of drilling activity through 2010 coupled with efficiency gains has already dialed in a certain amount of production growth in 2011. Based on the current gas rig count of roughly 940, we expect U.S. onshore production to average 56.6 Bcf/d compared to 55.8 Bcf/d in 2010."
Any "movement in forward strip prices above the $5/Mcf level will be met by a wave of hedging that will either sustain or even increase gas drilling activity," said the BMO team. "If the gas rig count holds at or near current levels, we would expect only modestly stronger prices in 2012...Indeed, we believe that $5.00 may represent the top end of the long-term annual trading range for natural gas unless U.S. natural gas demand receives a significant boost or there are liquefied natural gas export facilities constructed."
Analysts with Barclays Capital offered a few possible surprises for 2011. Among them, they said the rig count could grow.
"Many expect that the rig count will continue on a downward trajectory in response to lower prices," said the Barclays team. "We expect that in 2011 there will be only a modest drop and drilling activity will remain high, at more than 900 rigs. It would be incredible if producers instead surprised the market by growing the rig count. Is it possible? We would say yes.
"A sizable chunk of today's new drilling is essentially 'free,' paid for by associated liquids revenues or through joint-venture carries. An additional quantity is protected through hedging, and notably, the percentage of production hedged rapidly caught up with levels in previous years as 2010 drew to a close, despite a flatter and lower forward curve."
Another possible surprise this year would be a "structural change in producer behavior," they said.
"We have long argued that producers have a business model that shoots their product in the foot. They desire high gas prices, yet individually seek to maximize production on a company-level basis. No one can influence price by pulling production from the market. Independents have been able to get by on hedges into a higher forward market, easy borrowing and oil and liquids revenue; however, if these all dried up, would a return-on-capital model replace a production growth one?
"It is difficult to time when this could happen but the current producer business model looks unsustainable for dry gas producers in perpetuity," said the Barclays team.
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