The weather (or lack thereof), record storage levels and the credit crunch are likely to dominate and pressure natural gas pricing across the United States for at least two months and up to the end of the year, according to several energy analysts.
Natixis Bleichroeder Inc. on Friday cut its U.S. gas price forecast for 3Q2007 to $6.00/MMBtu from $7.00 and the 4Q2007 estimate to $7.00/MMBtu from $7.25. The full-year forecast remains unchanged at $7.50.
“The main reason for decreasing our gas price assumptions is the record level of storage and currently low prices that seem likely to persist into early fall 2007,” said Natixis analyst John White. “Thus, we believe that for the remainder of 2007 and especially in the latter half of September U.S. natural gas prices will remain under pressure.”
Weekly gas storage injections to date “have been normal,” White said, but “the high level of storage at the start of refill season has created another temporary oversupply situation as we enter the fall shoulder season. In the absence of tropical activity, we see little near-term support for natural gas prices and would not be surprised to see the front month contract price drop below $5.00/MMBtu.”
The Natixis analyst said “clearly, if natural gas prices persisted for several months below $6.00/MMBtu, there should be a decline in drilling activity, which would ultimately reduce domestic production. That said, we do not expect that situation to occur in [the second half of 2007] or 2008. Overall…we expect the U.S. natural gas market to be fairly balanced. If so, that would mark a significant change from the recent past.”
Ron Denhardt, vice president of natural gas services for Strategic Energy and Economic Research Inc., wrote in a note that with the exception of hurricanes Katrina and Rita in 2005, “hurricanes have had only a modest impact on prices.” However, “the credit crunch could force liquidation of positions in energy markets to raise cash. Natural gas prices may be driven up because of large short positions being liquidated but oil prices are more likely to be subject to downward pressures.”
Barring significant production losses because of storms, Denhardt said Henry Hub natural gas prices could decline below $5/MMBtu in September or October, while a hurricane on the scale of Katrina or Rita could drive prices well above $10/MMBtu.
Assuming normal weather and only a 50 Bcf production loss due to hurricane activity, working gas in storage is expected to end October at 3.5 Tcf, compared to 3.45 Tcf last year and a five-year average of 3.27 Tcf, Denhardt said. Because of the high level of working gas storage last year, Henry Hub prices averaged $5.30/MMBtu in September and October.
To deliver a market return on capital deployed in the current environment, Andrew Coleman of Friedman, Billings, Ramsey & Co. Inc. (FBR) said he was “looking for soft spots on a bumpy ride” for exploration and production (E&P) companies.
“Natural gas overhang persists,” Coleman said in a note. “We estimate a gas storage overhang of 200 Bcf to 350 Bcf exists, relative to the two-year and five-year averages, respectively. To avoid a refill level above last year’s 3,450 Bcf, we would expect injections to average 55 Bcf per week — slightly below the five-year average of 65 Bcf per week.”
Based on its overall analysis, FBR cut its Henry Hub gas price to $6.87/Mcf from $7.50. In 2008, FBR’s price was slashed to $6.50 from $7.50, and in 2009, prices were cut to $6.75 from $7.25. FBR is estimating a gas price in 2010 of $7/Mcf.
“Weather catalysts cannot be ruled out as we enter the peak of hurricane season,” and “few companies have hedged much in 2008 so far, so we estimate that TEV [total enterprise value] multiples would expand by 15% if lower prices were to prevail,” Coleman wrote.
Looking back at 2Q2007 results, FBR showed companies with average LOE [leasehold operating expenses] and production taxes of $1.65/Mcfe and average DD&A [depreciation, depletion and amortization] costs of $2.30/Mcfe. “If our scenario of lower natural gas prices plays out, we would expect to see some service cost compression for LOE and reduced production taxes.”
FBR is holding to its thesis that Rocky Mountain producers “hold the greatest upside once infrastructure expansions are completed in early 2008, although we recognize that in the near term, these companies continue to see the weakest pricing environment.”
Meanwhile, John Gerdes of SunTrust Robinson Humphrey/the Gerdes Group (STRH) said capital costs for E&Ps have fallen from the highs of last year, but gas prices will have to move into the $8.00/Mcf area to deliver a market return on the capital spent.
“E&P capital intensity of approximately $4.40/Mcf and unleveraged cash expenses of $2.10/Mcf equate to a current E&P cost structure of $6.50/Mcf,” Gerdes wrote. “In addition, assuming a 50 cent/Mcfe discount to reconcile E&P company gas price realizations to Nymex [New York Mercantile Exchange] Henry Hub implies a Nymex normalized cost structure of $7/Mcfe.”
Consequently, said the STRH analyst, to generate a simple cash-on-cash unleveraged pre-tax return of 11% (i.e., large-cap E&P weighted average cost of capital) requires an approximate $7.80/Mcf Nymex natural gas price. Notably, STRH’s “Market-Equity-Return” valuation “currently suggests a roughly $8/Mcf Nymex gas price is necessary to deliver a market return on capital.”
STRH’s E&P coverage portfolio in 2Q2007 indicated slightly higher production and costs.
“In aggregate, second quarter production was 0.5% above our expectation and accordingly our full-year ’07 production was raised 0.5%, while 2008 production has been increased 1.0%,” Gerdes wrote. “As a consequence of the 2Q2007 results, 2007 unleveraged cash expenses were increased 1.0%, while overall capital intensity was largely unchanged, though certain E&P business models…did experience minor upward pressure.”
To balance North American gas market fundamentals in 2008, the STRH analysis “suggests gas-directed drilling activity needs to increase almost 10%. A 10% increase in drilling activity translates to about 10% higher E&P capital spending than the analysis presented…and implies the E&P industry would be 10-20% free-cash-flow negative in 2008. Moreover, given a 10% increase in North American drilling activity, our 5% inflation expectation for 2008 may prove optimistic.”
Against the backdrop of low-$7.00/Mcf gas and mid-$60/bbl oil prices, E&P gross profit margins “should contract about 6% in 2007 after contracting 17% last year,” Gerdes wrote. “Notably, in an $8.50 gas price environment next year, which should encourage a 10% increase in drilling activity, cash and gross profit margins should expand 15-20%.”
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