Oil’s ‘wild ride’ over for now; natural gas heads into soft

Posted on 18 November 2008

By Linda Hsieh, assistant managing editor

The days of $147 oil may not be gone forever, but don’t go looking for it to come around again anytime soon. Certainly not in 2009 anyway, analysts say.

With a financial crisis ripping through the global economy and oil demand down, the price of oil will likely “fiddle around below $100” in the coming year, one analyst said. Another commented on 1 October that crude could settle in the low-$70s by the end of 2008. In fact, as of 22 October, the price of oil had already plunged below $70.

Even more than the growing volatility of the oil price, however, they say the bigger concern is the natural gas market. An overabundance of supply has put a considerable damper on prices – from $14 down to under $7 in recent months. That softness will likely carry through into 2009, with potentially significant impacts on the North American rig count.

The world economy

As of October, the economic crisis and its effects were still unraveling. The US Congress had passed a $700 billion bailout plan. World leaders appeared ready to take aggressive measures to help the economy as well, with an international economic crisis summit planned for 15 November. How this all will play out is still far from certain. How it might impact the oil and gas industry is another question mark.

“It’s a little early to say, but it’s going to make capital harder to get for E&P companies and affect their activities,” said Marshall Adkins, managing director for Raymond James & Associates. “That’s mainly the smaller companies. The larger companies have huge free cash flow. But independents and anyone with any amount of debt is going to have issues.”

And because there are consolidations anytime there’s a downturn, this slow economy could become prime grounds for cash-rich companies with strong order books to buy up small guys overextended on debts, said Eugene Murphy, investment principal for Kenda Capital.

There is a silver lining for this industry, however. If anybody is going to get a loan in this economy, it will probably be us, said George Littell, partner at Groppe Long & Littell. “I think (the downturn) points to the fact that the oil and gas industry is a lucrative one. We’re the companies with the real assets. When they’re sorting out who gets credit, oil and gas companies are at the top of the list.”

Rather than the oil price or the credit crunch, the real snag that the industry is about to hit is with natural gas, Mr Littell emphasized.

“I think the more material problem for rig contractors is that the industry has become a victim of its own success,” Mr Littell said, explaining that contractors and rigs are actually drilling so efficiently, they oversupplied the market.

The industry is getting too good at getting natural gas out of the ground, especially with the shale plays, he said. Drilling long horizontals with multiple stages of fracturing has turned out to work quite well on most of the shales. Not only that, but the industry is also “trying to drill (the shales) all at the same time. You’d think you’d develop the most economic ones first, then move on to the next in order of size and complexity. That’s not what the industry is doing,” Mr Littell said.

Another factor that could make a significant difference is the number of LNG plants coming online in late 2008 and early 2009. These plants, located all over the world, were originally supposed to be more spaced out when construction began three or four years ago, Mr Littell said, but delays and other glitches have pushed them all together to start within a short time span.

“All in all, (the LNG plants will bring on) about a million and a half barrels a day of oil equivalent. We’ve gone nearly a year with essentially no increments to LNG supply, and, in the next six months, there’s going to be a bunch of it,” he said.

In fact, these supplies don’t even have to get shipped to the US in order to have an effect here – they already are more likely to get sent to Europe and Asia rather than to the oversupplied US market. Simply having access to additional LNG “will put pressure on the domestic gas market,” Mr Murphy pointed out.

So with too much shale gas and global LNG, how low can we see natural gas prices go in 2009? “We’re at $6.75 next year, which means you’ll probably go below that for periods of time,” said Mr Adkins.

Mr Littell was less optimistic, commenting, “There is too much gas built up. If we get something close to normal weather this winter, there will be a good shake-out of natural gas prices. … You can see it test $5, probably around February.” He also forecast a decline in the North American rig count in the 10% to 20% range.

Mr Murphy declined to provide a forecast on natural gas prices but noted that the number of wells drilled could drop by anywhere in the 5% to 30% range, depending on whom you ask. “There are lots of projections out there, anything from a flat market to the latest numbers out of Canada suggesting (drilling activity in Canada will drop) from 17,500 in 2008 to 16,500 next year. It’s all over the place.”

Shrinking budgets

Although the winter season usually does bring more bite to natural gas prices, at least somewhat, the upcoming winter could be too late to help the 2009 market because companies are already putting together CAPEX budgets for next year. “People are already looking through to the end of 2009 … if they think the market is going to soften next year, they’ll start to cut back on their CAPEX plans,” Mr Murphy said.

Indeed, news have been steadily trickling out, especially from smaller and independent operators, announcing reductions in 2009 budgets. For example, SandRidge Energy, an Oklahoma-based E&P company focused on West Texas resources, announced on 2 October that it’s reducing its ’09 budget from $2 billion to $1 billion. The reduction “is a direct response to recent declines in natural gas prices,” the company said in its announcement.

Petrohawk Energy, which focuses on ArkLaTex, Oklahoma and the Permian Basin, announced a similar budget cut the day before, from $1.5 billion to $1 billion. The reallocation of capital reflects an increased emphasis on development of non-proved locations in the Haynesville and Fayetteville shales, the company said.

Even large independents haven’t been immune. Chesapeake Energy announced in late September it is reducing its CAPEX budget for the second half of 2008 through the end of 2010 by approximately $3.2 billion, or 17%, in response to the approximate 50% decrease in natural gas prices since June 2008 and surplus concerns. The company also plans to reduce its current operated rig count of 157 to approximately 140 by the end of 2008 and to keep that number flat through 2009 and 2010.

In addition, Chesapeake has shut down approximately 100 million cu ft/day of net natural gas production, citing “unusually weak wellhead natural gas prices that are substantially below industry break-even costs.” This represents approximately 4% of the company’s current net natural gas and oil production of over 2.3 billion cu ft/day of natural gas equivalent.

Volatile oil

Amid discussions about lower natural gas prices, it’s also important not to overlook the price of oil. That picture has become much more volatile in recent weeks and months. From a record high in July 2008 of $147/bbl, it dipped below $70/bbl by late October – that’s about a 50% drop over about a three- to four-month period. On 23 October, in fact, oil closed at just above $64/bbl.

How serious is this price drop? It seems like $65 or $70 oil is nothing to cry to over. If you think back to the ’90s, many operators would’ve been thrilled with even $50 oil. Yet, everything is relative. Now that the world knows $147 oil is possible, have our expectations changed?

OPEC is certainly worried. The group first called for an emergency meeting in Vienna on 18 November, then decided the situation was too pressing and moved the meeting up to 24 October. The result was a 1.5 million bbl/day cut in production, effective 1 November. “Oil prices have witnessed a noticeable collapse … unprecedented in speed and magnitude … which may put at jeopardy many existing oil projects and lead to the cancellation or delay of others,” according to a statement released after the meeting. They also noted the financial crisis and its “noticeable impact on the world economy.”

Certainly, consumer demand for oil has been falling and continues to drop. On 10 October, the International Energy Agency (IEA) slashed its 2009 oil demand forecast by 440,000 bbl/day. World oil demand is expected to average 86.5 million bbl/day next year, according to the report.

“(The demand drop) is a response to $145 crude and $4 gasoline. That’s exactly what had to happen,” Mr Adkins said.

“People are cutting back wherever they can,” added Mr Murphy, noting that one X factor to demand could be Americans’ driving habits. “If Americans would just wean themselves off pickup trucks, they wouldn’t need quite as much as they consume.”

Mr Littell agreed, pointing to the fact that consumer sentiment is already pushing US automakers away from gas guzzlers. “The market is all small vehicles and hybrids now. You can’t sell big cars. If they continue that for a long period of time, it starts making a substantial difference (in oil demand).”

Where is oil price headed?

It’s unlikely that crude prices will return above the $100 mark anytime soon, the analysts agree. “Next year, we’ll probably fiddle around below $100. How low it’s going to go, I have no idea,” said Mr Murphy, but he pointed out that “this is a short-term glitch. We’re still not keeping up with supply and demand in the long term.”

Even so, $147 oil was definitely an abnormality, Mr Murphy acknowledged, citing the weakness of the US dollar as one factor.

Mr Littell agreed it was an atypical event and said he believes the entire thing was an unplanned blunder. The IEA had forecast an increase in non-OPEC production in 2007, leading OPEC countries to cut back on their output, he recounted. But the forecast increase never happened, and OPEC didn’t begin increasing production again until late 2007. “Oil demand was up in 2007 but production was down. It wasn’t designed, it was just a mistake that took them a while to correct,” he said.

Mr Littell said he believes oil could stay in the low-$70s in 2009. And if you think that sounds like it’s on the low side, try to put it in line with your pre-$147-oil expectations. “Stop and think about it for a minute: What was the oil price when 2008 began? Low-$70s,” he said. “We just had a wild ride.”

$70 oil is by no means bleak, and Mr Littell believes this is still a great time to be in the business. “I don’t think we’re going to see $147 oil again anytime soon, but $70s will do just nicely. And if operators can make good money at those prices, I think contractors ought to, too.”

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