Replies to post #354 on The Rising Influence of Rising Affluence

[DewDiligence]

Since wsj.com is a subscription website, I posted the full article.

›Gas Drillers' Painful Growth Paradox

By LIAM DENNING
SEPTEMBER 25, 2009

Growing, growing, gone? America's oil and gas exploration-and-production industry faces a shakeout.

The E&P sector is addicted to high growth. That is expensive: E&P capital expenditure has outstripped cash flow pretty consistently over the past decade, estimates James Murchie, founder of Energy Income Partners LLC. In contrast, Exxon Mobil, consistent winner in terms of return on capital, has reinvested just 41% in that time.

In turn, E&P capex leaves little for dividends and buybacks, meaning investors demand more growth, meaning ... you get the idea. The model works when commodity prices are rising and capital is plentiful. But the price of natural gas -- the fuel that constitutes more than two-thirds of the sector's reserves and production -- has slumped on oversupply. That is what happens when every company needs superior growth rates.

Bob Gillon of consultancy IHS Herold points to a structural disadvantage as well. E&P companies' appetite for growth, especially when energy prices are rising, leaves them "having the most amount of money to spend when costs are the highest; the least to spend when costs are the lowest."

A growing realization of the challenge should curtail access to capital. Bank credit lines, predicated on the value of reserves, are being renegotiated.

Consolidation, resisted at the trough of the market, also should pick up. That would help in an industry where the largest company accounts for only 3% of production. That is one reason why U.S. natural gas is so cheap compared with OPEC-influenced oil.

Larger, better-capitalized companies would be better placed to develop America's vast gas reserves without relying on an intravenous drip of capital to fund it. Investors, in turn, could look forward to more sustainable rewards.‹

[Democritus_of_Abdera]

Regarding E&P appetite for growth ...

<<E&P companies' appetite for growth, especially when energy prices are rising, leaves them "having the most amount of money to spend when costs are the highest; the least to spend when costs are the lowest." >>

In my opinion, an additional consequence of an unrestrained “appetite for growth” is cut-throat competition when fundamentals first begin to turn against an industry. I would rather see an “appetite for profit” which, if a general industry attitude, is evidenced by capacity constraints in down cycles; constraints that persist until profit margins are once again solid.

I have become convinced that the gas industry, for one, will not constrain capacity long enough to return to solid profit margins in the absence of a strong cyclical increase in demand. This conclusion has been derived from statements such as that in the following exchange in the Q&A of Southwestern Energy’s July 31, 2009 CC.

<Q – Jason Gammel>: ... you guys had mentioned returning to a more normal price environment over the coming weeks and months. Could you just give us your outlook on the macro environment, what you see just in terms of production in the U.S. because of all the rig weighdowns, that sort of thing?

<A – Steven Mueller, President and CEO>: ... I think in general, our general philosophy is that there’s some forces in play, especially with the overall production and the low rig count that should have gas price increase in the future. We also think it’s going to be very volatile. We think it’s going to go up and it can come down as fast as it goes up, and we think that will happen certainly for the next year or so. And so we’re just watching it, and as we can take some more hedges, we’ll take more hedges, and we’ll make decisions as it plays out. And again, the key to what we’re doing is flexibility. If prices look like they’re going to go up in 2010, later this year, we won’t drop those couple of rigs I mentioned in the Fayetteville. If they’re staying the way it is today, looks like they’ll stay that way for a while, we’ll make decisions then and go from there.

It is worth noting that SWN’s current production constraints are involuntary, i.e. they have been dictated by problems in the Brookwood pipeline that collects the produced gas. I believe that even in today’s environment, SWN would continue to ramp-up production to maximize cash flow if they could.