All-in finding and development (F&D) costs to produce U.S. natural gas are $4.00-5.00/MMBtu, but with benchmark Henry Hub spot prices hovering at $2.50/MMBtu, exploration and production (E&P) companies are in a tough spot, particularly if they have few hedges in place, no oil component in their portfolio, or are just beginning to transition to oily projects, Standard & Poor’s (S&P) analysts said last week.

In their report, “How Strong Crude Oil and Weak Natural Gas Prices Affect Credit Quality in the Energy Sector,” analysts Carin Dehne-Kiley and Thomas Watters said S&P’s 2012 baseline forecast of $86.32/bbl for the benchmark West Texas Intermediate (WTI) crude oil price “bodes well” for E&Ps that focus on oil, as well as oilfield services and contract drillers.

“The outlook for natural gas prices, however, remains bleak. Prices continue to spiral down: The benchmark Henry Hub spot natural gas price is currently hovering around $2.50/MMBtu, versus nearly $4.50 at the beginning of 2011, while the one-year futures price is about $3.00.”

Gas prices aren’t expected to rebound anytime soon.

“In our view, the price of natural gas is the biggest threat to the credit quality of companies in the energy industry this year — particularly in the U.S. independent E&P sector, where natural gas constitutes about 60% of the average proven reserve base for the companies we follow.”

Success in producing onshore gas hasn’t been matched by an increase in demand. “Dry natural gas production increased 20% between 2007 and 2011, while natural gas demand grew only 4% over the same period.”

Last year many operators had “strong” hedges in place or they may have believed prices would strengthen. Some also may have not wanted to lose rigs or personnel, said the analysts. However, a lot of hedges since have expired and most operators have satisfied their held-by-production requirements. They may be more willing to rein in uneconomic production, or less willing or able to incur debt to drill for natural gas, said Dehne-Kiley and Watters.

Demand for gas isn’t likely to grow this year, said the analysts. Domestic demand basically was flat in 2011 year/year, “as growth in electricity generation offset declines in residential and commercial demand (primarily for heating).” The Energy Information Administration (EIA) is projecting total U.S. gas consumption will increase by about 2% this year, but because of the warm winter, “we believe EIA’s heating demand projection is probably too high” and “will rise just 1% in 2012…”

Because the analysts believe all-in F&D costs are about $4.00/Mcf, or $5.00/Mcf including debt-servicing costs, “issuers are not currently covering their all-in costs with unhedged production revenues, let alone generating economic returns. The law of economics would state that companies should stop producing natural gas now” to reduce output and stabilize prices.

Several U.S. producers have curtailed some production, most notably Chesapeake Energy Corp., which has shut in .05 Bcf/d, and ConocoPhillips, which shut in 100 MMcf/d. Encana Corp. said Friday it also would shut in gas (see related story).

However, reining in drilling and curtailing existing production takes time, said the analysts. “Thus, there is likely to be about a six- to nine-month lag before we see the impact of these cuts on volumes.”

For the most part, high oil prices should be able to bail out E&Ps — if they already have established positions in wet plays. And natural gas liquids (NGL) prices should hold up “as long as demand — primarily from the U.S. petrochemical industry — continues to grow.” The market to date has absorbed all of the recent increase in domestic NGL supply “and we expect that to be the case through at least 2012.”

A separate report issued Friday by Moody’s Investors Service said several speculative-grade E&Ps appear particularly vulnerable to low natural gas prices, based on the amount of natural gas they produce and their tight liquidity.

And like S&P, Moody’s expects gas production to continue to rise even if the number of new dry gas wells is cut in half.

“Five ‘B’ rated E&Ps that have gas-weighted production — Comstock Resources, Exco Resources, Penn Virginia, Quicksilver Resources and Carrizo Oil & Gas — look particularly exposed to weak natural gas prices in 2012,” the report noted. “Unlike some of their competitors, these companies face greater stress from such factors as tight liquidity, strict covenants or approaching debt maturities.”

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