Just about everywhere one turns these days, there's a perception that natural gas and global oil supply are tighter than any analyst might have predicted last fall-and that for the foreseeable future, we're likely to witness strong commodity pricing and, in tandem, strong E&P stock performance.
Take the domestic natural gas market. Recent Energy Information Administration (EIA) data suggest that U.S. onshore production is flat to down this year, observes Joseph Allman, E&P analyst for JPMorgan Securities Inc. in Houston.
The cause: producers have been dropping rigs-this at a time when overall normal weather has increased demand versus last year. Indeed, between last November and late May 2007, the U.S. onshore rig count dipped from 1,651 to 1,540-a 7% drop.
At first blush, this decline appears to defy conventional wisdom since commodity prices and E&P cash margins are strong. However, explains Allman, "all-in drillbit finding costs are still very high, making [upstream] economics tight. Given current costs, [producers] need close to $10 per million Btu Nymex gas prices to get adequate cash margins that provide sufficient rates of return on drilling."
For at least the next four years, the analyst's supply/demand model suggests an undersupplied gas market, which bodes well for strong commodity prices and E&P cash margins and, in turn, better rates of return and stock-price performance in the upstream.
As for those gas-weighted stocks likely to outperform in this environment he envisions, Allman cites Chesapeake Energy among large-cap producers; Southwestern Energy among midcaps; and Goodrich Petroleum among small-caps.
With 14% to 18% production growth expected in 2007 and improving operations in key areas like the Barnett and Fayetteville shales, Chesapeake-the cheapest stock in its peer group-has more momentum than it has had in a long time, he says.
"On a net-asset-value (NAV) basis, Southwestern is also trading well below its peers and the overall E&P group," the analyst adds. "It also has improving operations in its core Fayetteville-shale operating area, with recent wells showing above-average initial production rates."
Although Goodrich is trading above its peer group on an NAV basis, it nonetheless has more leverage to gas than all other E&P companies that Allman follows, "so its value rises more than any other [producer] in response to a tight natural gas market and strengthening gas prices."
The global oil supply situation is similarly tight. "There's no question that OPEC's excess capacity remains near 30-year lows, most likely around 2 million barrels per day-under 3% of global demand," points out Pavel Molchanov, an analyst with Raymond James & Associates in Houston.
Thus, with OPEC bumping up against capacity limits, the ability of non-OPEC producers to increase production is critical. But can they deliver this growth-and on a sustainable basis? "Almost certainly not," answers Molchanov.
Given the mature characteristics of much of non-OPEC oil production, it doesn't appear feasible that non-OPEC countries as a group will be able to deliver meaningful oil-supply growth, he contends.
"Non-OPEC growth is highly dependent on growth in Russian oil output-which accounted for fully two-thirds of non-OPEC production growth during the 2000-06 period," Molchanov says. In fact, of the 5.3 million daily barrels of increased non-OPEC production during that time frame, Russia provided 3.5 million daily barrels, or 67%.
However, given current policy in Russia-including creeping nationalization of energy assets-he believes that country is unlikely to post the growth it experienced in the early part of this decade.
Therefore, the world is likely to continue in an environment of a "wafer-thin excess-capacity cushion" for the foreseeable future, the analyst predicts. "Given this tight supply/demand equation, threats of even minor supply disruptions are bound to have a large impact on already volatile oil prices-and the oil markets look set to continue to price in a substantial geopolitical-risk premium."
Look for the futures market to suggest oil prices significantly higher than most analysts forecast. Recently, the WTI futures calendar for 2008 and 2010 averaged around $69 per barrel.
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