With 10 weeks to go in the traditional storage injection season, the bears are picnicking at the expense of exploration and production (E&P) companies, feasting on the rise in domestic natural gas production, a large storage overhang, continued high operating costs and the current credit market woes.
To deliver a market return on capital deployed in the current environment, some energy analysts estimate that gas prices will need to move higher in the range of $8/Mcf — but based on current numbers, another firm cut its gas price forecasts.
Energy analyst Andrew Coleman of Friedman, Billings, Ramsey & Co. Inc. (FBR) said he was “looking for soft spots on a bumpy ride” for E&Ps.
“Natural gas overhang persists,” Coleman said in a note to clients. “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.”
Henry Hub pricing has averaged $6.30/Mcf so far in 3Q2007, and based on FBR’s overall analysis, the energy firm cut its gas price forecast. For 2007, 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.”
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/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 a note to clients. “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.”
In a low-$7/Mcf gas and mid-$60/bbl oil price environment, the STRH E&P portfolio is about 30% free-cash-flow negative. In 2008, assuming $8.50/Mcf gas and $70/bbl oil, a level of drilling activity comparable to 2007 and 5% cost inflation, “the E&P industry appears likely to remain modestly free-cash-flow negative,” said Gerdes.
To balance North American gas market fundamentals next year, 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/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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