Is a Natural Gas Supply Bubble Forming?--Page 2

Is a Natural Gas Supply Glut Unavoidable?
One thing we've noticed is that the migration of industry resources to the Haynesville will have an impact on other producing regions, so activity in other regions may moderate as the Haynesville sucks resources away from others. This effect is already apparent in the tightness found in the drilling rig market--especially for higher-horsepower top drive rigs with big pumps. Steel tubes have also been in short supply and could limit the E&P industry's ability to increase drilling plans and capital programs significantly beyond budget in 2009.

Looking beyond E&P, there could be significant midstream bottlenecks in 2009. A lack of pipeline takeaway capacity has plagued Barnett Shale producers from time to time recently, and it's likely to haunt the dreams of producers envisioning a rapid escalation of production out of the Haynesville and other shale plays. For example, the Fayetteville Shale (just north of the Haynesville) is primed for a sizeable increase in production over the next 12 months, and the Barnett should continue to book steady production increases as well. Production from both of these regions will be competing with new Haynesville production for pipeline access to eastern and southeastern markets. Although it's still a bit cloudy from our perspective, we see the potential for Haynesville producers relying on interruptible pipeline access to get disrupted by Barnett and Fayetteville producers with longer-standing firm pipeline capacity agreements.

Bigger picture, when faced with a futures curve in the $7-$8 per mcf range, we find it difficult to imagine E&P companies will be drilling as aggressively as they were at a futures curve in the $10-$12 range. So we'd expect drilling activity to taper off over the next few months. Given present well costs and industry's interest in earning a positive return on those well costs, it's hard to forecast natural gas prices below $6 to $7 for an extended period of time. Why? The base decline rate is still high enough that the E&P industry needs to drill somewhat aggressively to maintain flat production. As long as this fundamental stays intact, using marginal well cost plus a return on capital seems to be a good way to think about the floor price. However, as more and more natural gas shale plays are layered into the base of production, the decline rate should start to moderate. Although our estimates suggest that lower base decline rates will take many, many years to materialize (as new well production--which has a steep decline rate--becomes less significant in the overall supply picture, and the lower decline, older shale wells become a bigger piece of total supply), we will monitor this fundamental closely given its impact on our valuations.

Bottom line: We don't think an imminent natural gas supply bubble is obvious, but we will take the threat of much greater supply levels very seriously when thinking about our forecasts. It would be foolish to ignore the potential impact of the multitude of shale plays that have been discovered and that are proving to be economic with gas prices above $9. In our opinion, we think it would be equally foolish to simply point at all of the announced shale plays and conclude a gas supply glut is inevitable. This line of thinking ignores infrastructure and deliverability constraints as well as the likelihood that drilling will slow down considerably when gas prices fall below $7 per mcf. In the short run, it's worth considering that given the short-duration leases in the Haynesville--where well economics are promising but development is still in the very early stages--the potential for unusually aggressive drilling even in the face of lower prices (in an effort to hold quickly expiring leases through production) could place some added downward pressure on natural gas prices in the near term, especially if winter weather is unusually warm.

Discussing Our Current Valuations
Those who follow our E&P company star ratings know that we have many rated at 5 stars presently. Most of these companies are weighted toward natural gas production and prices. For three years running now, we've thought the valuations of these companies have been attractive in the August to October time frame--a time when natural gas prices are seasonally weak and winter weather uncertainty builds.

Many E&P stocks look cheap today in our DCF models. In addition to our DCF models, we look at enterprise value to flow-based measures and reserves-based measures for greater context. Again, many of the companies look cheap through these valuation lenses. Many sport enterprise values that are less than 5 times our estimates for their 2009 EBITDAX (earnings before interest, taxes, depreciation, depletion, amortization, and exploration expense).

Looking at one example, we presently estimate  Quicksilver's  2009 EBITDAX at $940 million (assuming average daily production of 396 mmcfe per day and the present futures curve less hedges and basis) versus a present enterprise value of roughly $4.5 billion. We also expect Quicksilver will be able to boost production by more than 20% in 2010. So the market is offering Quicksilver's rapidly growing production (and EBITDAX) at a historically low multiple. We also think proved reserves can reach 3 trillion cubic feet by the end of 2009, so our present EV/year-end 2009 proved reserves estimate shakes out to roughly $1.50--far lower than where we'd expect transactions to be taking place then.

Some may argue that the low valuations are somewhat warranted. Many smaller E&P companies like Quicksilver could face head winds in 2009 should gas supply continue to rise and winter weather tilt to the warm end of the spectrum. We're keeping a close eye on companies that are especially financially levered, with financing strategies that involve selling assets (since bidder appetite could be weak in the short run) or significant infusions of external capital. However, weighing these presently vivid downside risks with the potential for many of the E&Ps to develop new resources in an attractive natural gas pricing environment over the next five to 10 years, we think many of the E&P companies look like compelling investment propositions at current valuations.

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