For the past several years, we have been publishing U.S. natural gas production surveys of publicly traded companies. The bottom-line story has remained essentially the same throughout this entire time: U.S. natural gas production is heading firmly downwards, despite a massive increase in drilling activity.
Remember, our Q4 2003 survey, published in February, found a 1.5% year-over-year production drop. For the full-year 2003, the average YOY decline was approximately 2.3%. How does the U.S. gas supply situation look now? We ask this same question every quarter, but the answer somehow just doesn't change very much. As our Q1 survey shows, U.S. publicly traded E&P companies are now showing a 4.2% YOY gas production decline. The key point to make remains quite simple: As before, we see no significant near-term catalysts to alter the declining supply picture, and therefore price rationing remains the only viable option to bring the market into equilibrium. With both front-month gas contracts and the 12-month strip staying well above $5/Mcf since December, we believe pricing in the commodity markets reflects the tight supply environment - even if the equity markets (and most energy analysts) have yet to awaken to this reality. Even though the 2004 First Call consensus forecast for gas prices has increased from ~4.50/Mcf to ~$5.00/Mcf over the past five months, the current $6.30+ price level is still nearly 30% higher than street consensus and 5% higher than our $6.00/Mcf forecast.
Survey says: U.S. natural gas production fell 4.2% YOY, 0.5% sequentially.
As mentioned above, our survey results suggest that after adjusting the data for property acquisitions and divestitures, U.S. gas production declined 4.2% on a year-over-year basis and 0.5% sequentially. To put this figure in context, our four surveys from 2003 on average posted YOY declines of 2.25%.
Even though this most recent data does seem to imply that the year over year gas decline rate is accelerating, we would caution that there appears to be substantial volatility in these YOY numbers.
Our survey results also bring into question the data from the Energy Information Administration showing U.S. natural gas production on the rise. Though EIA data for 2003 (the latest available) has gone through several downward revisions, it still shows a YOY production increase of ~0.6% for the entire industry last year.
This conclusion from the EIA seems to defy common sense when one considers that our surveys cover 48 of the largest natural gas producers in the United States, representing roughly 60% of total domestic gas production. Given that 60% of production was down 4.2% YOY in Q1, the other 40% would have to be up a whopping 6.3%, in order for total production just to break even! Expecting such a massive level of growth from the small, mostly privately held, producers outside our survey is wishful thinking, at best.
Production declines continue, despite continued growth in drilling activity.
Despite the 20%+ increase in drilling activity over the course of the past 12 months, it seems clear to us that U.S. natural gas production continues to fall. This is contrary to what many of the natural gas bears have been suggesting over the past year. Perhaps more importantly, the majors (and gas utilities) continue to show the biggest decline in U.S. natural gas production, coming in this quarter at down 9.2% versus last year and down 1.0% sequentially. This is important since: 1) the majors and utilities represent a large proportion of U.S. gas supply; and 2) drilling activity among the majors and utilities has been essentially flat since the start of 2003. This indicates that further production declines lie ahead for this group.
This also brings to light an even more astonishing reality: the independents are driving nearly all of the drilling activity increases, with little production response to show for it. Specifically, the independents have been responsible for putting an additional ~80 gas rigs to work (a 34% increase!) since April 2003, and yet their corresponding production grew only 0.8% year-over-year and was actually down 0.1% on a sequential basis (compared to the Q4 sequential decline of 0.2%). Even though these results seem mediocre compared to the independents' massive level of investment, it is important to note that at current gas prices, these companies are making excellent returns on almost every prospect they drill. As a group, however, they have not been able to "move the needle" on U.S. gas supply.
Furthermore, we emphasize that only four of the independents in our survey kept the overall group from posting substantial declines - as was the case in Q4, as well. Without the large organic increases in production from Chesapeake Energy (CHK/$13.52/Strong Buy), EnCana (ECA/$40.87), Pioneer Natural Resources (PXD/$31.21/Strong Buy), and XTO Energy (XTO/$26.61/Strong Buy), the E&P group's YOY growth rate would not have been 0.8%, but rather a negative 2.9%! What about the private E&P companies?
As a caveat, we point out that while our survey covers about 60% of total U.S. gas production, its results are not necessarily reflective of the other 40% - which largely consist of smaller, mostly privately held, E&P companies. Given the vast number of these small players, it is impossible to get an accurate assessment of what their production is doing. However, as the table below shows, it is clear that the growth in gas rigs among companies outside our survey has lagged the independents included in the survey over the past 12 months. This realization, along with the fact that drilling prospect quality among smaller private companies is almost certainly worse than that of larger public companies, leads us to conclude that their Q1 production declined on a YOY basis, probably by as much as 3% to 4%.
Our bullish North American energy thesis has been, and continues to be, centered on the underlying problem of falling U.S. natural gas production. Much like in the 1970s, when oil production continued to fall, regardless of how many rigs were drilling, we think we are nearing (if not at) a similar crossroads in the U.S. gas supply picture. Given the inherent rate of decline in U.S. gas wells today, combined with what is still a muted response to drilling activity, we expect domestic gas production levels to continue trending south for the next several quarters. While this trend will almost certainly be led by the majors, the independents may not be able to reverse it as fast as many people might believe. As a result, expected year-over-year declines of 2.0% to 4.0% over the intermediate term should continue to hold average U.S. gas prices to a ratio versus corresponding oil product prices that is below the traditional 6:1 BTU parity. If oil prices remain near the $40/Bbl level, that would imply fair value for gas above $7/Mcf.