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Investor's Business Daily
Credit Crunch May Hit Natural Gas Drilling
Tuesday October 21, 6:47 pm ET
Alan R. Elliott
U.S. natural gas producers last year pulled off the biggest annual output jump since 1984. The industry is on track for a repeat performance for '08.
But the outlook for natural gas has gone hazy as economic and financial turmoil engulfs a growing number of firms.
Gas prices are 47% below their July peak. That would, under any conditions, set producers to battening hatches.
But the current pullback is complicated by tight corporate credit markets and withered stock values. These divide a growing number of gas producers from the sources of capital that have made their business models tick.
Chesapeake Energy (NYSE:CC - News) sliced $3 billion off its '09 budget in mid-September. Dunbar Resources (NYSE:DNR - News), Petrohawk Energy (NYSE:HK - News), Quicksilver (NYSE:KWK - News) and Sandridge Energy (NYSE:SD - News) soon followed with similar cutback plans.
All of these firms were highly leveraged, maximizing production by carrying heavy debt loads, says Ken Austin, a senior analyst at Moody's. They invested faster than they could generate cash.
"All the companies that have cut back spending at this point were way outspending cash flow," said Joseph Allman, an analyst with JPMorgan.
Beleaguered banks are in no mood to lend, especially to extended gas firms as prices plunge.
Recent budget cuts have pulled the overstretched gas firms back within their balance sheets, Allman said. But their production goals remain high. Projected 2009 increases range from 16% to 35%.
Others appear less durable. Falling gas and equity prices are threatening to bite into the checkbook drillers, the wildcat operators that thrive on small, revolving lines of credit. Collectively, these vulnerable independents could help make the industry's supply and price swings more volatile.
"The real question is, to what extent does this financial thing that's taken place exacerbate the kind of reaction you would otherwise have to a falling price?" said Harold Korell, chairman and CEO of Southwestern Energy (NYSE:SWN - News).
Producers manage each well site according to the cost basis of its development, production and land-lease expense. When fuel prices decline, producers first back off output at sites with the highest per-unit costs, where margins are first to dwindle to zero.
"That allows you to turn (your output) down or turn it up, based on your ability to bring capital or technical resources or equipment and services," said Michael Watford, chairman and CEO of Ultra Petroleum (NYSE:UPL - News).
Both up- and downturns can be extreme. The industry hurled more than 600 drilling rigs into service during the gas run-up that took prices from less than $3 per million btu to more than $9 in '99 and '00. The sudden oversupply reversed prices, to back below $2 by the end of 2001.
"Within six months 400 drilling rigs were laid down," Karol said.
Some say the industry is facing another such pullback. Goldman Sachs forecast on Oct. 12 that 350 drilling rigs would be idled in '09, and cut next year's EPS targets among drillers by 28% and by an additional 40% for '10.
Gas companies have slim margins to cope with lower prices.
"Last year, only 35% of the plays in the U.S. generated more than a 10% profit margin," said Phillip Stack, vice president with HIS. "In 2005, when we had $9 gas because of the hurricanes, 85% were 10%-or-better profitable."
But have producers backed off since gas prices began tumbling in July? Allman conducted an informal poll of operators.
"Overwhelmingly the answer is no," he said.
Hurricanes Gustav and Ike to some degree staved off the need for voluntary cuts by shutting in virtually all of the Gulf of Mexico's seven billion cubic feet per day of offshore production in September.
Gas futures perked up briefly after the shut-ins, then settled back to 10-month lows. The Minerals Management Service says 2.7 billion cubic feet of daily output remains offline.
Is it possible, with that kind of production loss, that the natural gas industry is still oversupplied?
"Yes, it is," Hartford said. "And that's driven by the growth of the Barnett shale."
Shale plays like the Barnett are the other wild card that could affect the industry's pending pullback. The Barnett, in and around Houston, fostered technical developments that opened up shale gas drilling across the U.S. Unlike conventional wells, shale wells start with explosive production, then quickly taper to extremely low output.
"The more of those you drill, the quicker that gas surplus builds," said HIS' Stack.
But as overall drilling backs off now, will the industry see a rapid production decline?
"It's not that clear," Randy Ollenberger of BMY Capital Markets wrote in an e-mail response.
The economics of shale and other unconventional fields are now generally better than conventional plays. That means "all of the growth is coming from Barnett and East Texas," he said, and "that could be the last to back off."
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