The U.S. will return to a gas-shortage condition early next year, driving Henry Hub prices to $5 per MMBtu, predicts Phillip Pace, managing director, Credit Suisse First Boston. "I don't think gas will go [back to] $2.50," he told IPAA members at the recent midyear meeting in Tucson. "It's hard for anything to stay cheap for long." Oil and gas explorers haven't found as much gas as they've produced since 1978. "Now, we need to grow reserves, and history is not on our side." Better completions have resulted in a 20% to 29% decline rate. Those better completions don't create more reserves in new fields; they just deplete the reserves faster. The bonus for the producer is a faster, and higher, rate of return from new fields. At the same time, 3-D seismic has helped producers improve drilling success and make smaller fields more economic, he said. Smaller fields and faster depletion have set the industry on a treadmill that has forced producers to constantly increase activity just to keep production even. With 882 rigs drilling for gas in the first quarter of 2002, the best the industry could accomplish was a 5.4% year-to-year decline, Pace said, and 39 companies CS First Boston follows saw their production decline 10% or more. The industry drills better wells with 500 rigs working than 900, he added: the targets have been cherry-picked. When gas prices have climbed, operators have drilled lower-quality targets. The combination of factors conspired to leave the industry with essentially no increase in production at the end of 1999 and in 2000 even though the number of working rigs "exploded." He is bearish on gas demand. More than 20% of U.S. gas supply comes from the Gulf of Mexico, and that area is in decline despite the level of rig activity. With higher prices on the way as gas supplies shorten, "the oil-service guys will have the upper hand in six months." The challenge for operators will be to keep returns on investment competitive enough to encourage regeneration of the gas asset base, he said. For example, a typical 5-Bcf project in the Gulf drilled at a dayrate of $65,000 would return 12.2% at $3.40 per million Btu (MMBtu). But at $2.70, the project loses 12.4%. Canada still supplies a lot of gas to the U.S., but its reserves are declining. "I'm pretty sure Canada hasn't replaced production with reserves for 20 years," he said. Canada's biggest discovery in years was the Ladyfern play in northern British Columbia, but production from that area probably peaked last year and already is declining. Right now, gas producers are in a box. The marginal cost of gas is $3 to $3.50 per MMBtu and even as high as $4, depending on the company. Meanwhile, because of competition from other fuels and price pressure on demand, it's hard to sustain prices of more than $4 per MMBtu. "I am a huge believer in hedging to smooth volatility. At one point last year you could lock in a strip at $6. This business is too capital intensive to leave to the winds." Rebecca Followill, research analyst, gas and power, Howard Weil, New Orleans, told IPAA members that the electricity-generation industry goes through a cycle similar to that of gas. With huge electricity price spikes in 1998, the power-generation industry cranked up construction. From up to 15,000 megawatts per year, the industry moved to building up to 55,000 per year. As a result, plentiful electricity has driven prices to the lower extreme. In the gas industry's present condition-mature basins, accelerating decline rates and a market price of $3.50 per MMcf gas in most areas-producers need to accelerate drilling and strengthen their financial discipline to improve returns, she said.