“Bottom line, 2010 is going to be a grind,” according to a recent natural gas fundamentals report from analysts at Houston-based Simmons & Co. International.

“We don’t know when or where gas prices will bottom, but to us the central issue is not how low gas prices will go, but the duration of the weakness and on this front, we believe gas prices will be weaker for a longer period than many appreciate.”

Investors tempted to take a contrarian view should exercise caution, according to the report. “While we agree that investors have a uniform bias against gas, we believe investors are not fully factoring in the underlying negative fundamentals for natural gas that could extend both the depth and duration of weak prices, thus leading to either another leg down in pricing or an elongated period of sub-economic natural gas prices.”

A positive note for gas demand is the prospect of coal-to-gas switching, and low water levels in the Pacific Northwest, benefiting gas in the power sector. Industrial activity is recovering somewhat, as well. But domestic production and liquefied natural gas (LNG) supply will more than cover the demand bump-ups.

“Domestic production as evidenced by the Department of Energy 914 data and a surplus of corroborating evidence on multiple fronts is not only resilient, but is likely growing again,” according to the report.
“We expect the rapidly rising horizontal rig count, ongoing drilling efficiency gains, rising initial production rates, and relatively stable capital spending budgets (balance-sheet enhancements and active hedging) to drive domestic production growth during 2010 (up 2 billion cubic feet per day year-on-year by December).” Also a threat to gas prices: LNG supply additions of nearly 10 billion cubic feet per day globally will boost U.S. imports.

The 12-month forward gas strip (at $4.80 per MMBtu at the time of the report) is varying between $4.50 (meaningful coal-to-gas switching) and $6 (level at which substantial volumes of both conventional and unconventional natural gas projects are economic), according to the report.

“Given the multiyear backlog of drilling prospects, we expect the 12-month strip to trade near the low end of the range and would be surprised to see it exceed $6/MMBtu for an extended period in the near-to-intermediate term.”

Production growth will continue to be driven by E&Ps’ need to hold leases—almost regardless of price. “We estimate about 500 rigs could be required simply to hold existing acreage over the next three to five years,” according to Simmons & Co. The current gas-directed rig count is 593 horizontal and 364 vertical.

As for the economics of the major shale plays, questions remain, including how long drilling efficiency gains will continue, long-term reservoir performance, and the percentage of acreage positions proving to be noncore or uneconomic. These issues, too, will influence domestic supply.

Shale-play economics are open for debate.

“Producers appear to be considering acreage, seismic, other geologic and geophysical costs to be sunk in their drilling decisions, resulting in estimates of threshold economics below $5 per MMBtu for all major shale plays,” according to the report. “Were one to include these sunk costs to reflect a fully loaded investment base, substantially higher natural gas prices would be needed to justify full-cycle economics (about $6.50 per MMBtu).”

Yet, with an eye toward where the gas-directed rigs have been added to date, the report notes almost all of those plays appear capable of delivering 10% rates of return in a commodity market of sub-$5 per thousand cubic feet equivalent. The Haynesville, Marcellus, Anadarko Basin and South Texas plays lead in gas-rig additions since the trough of mid-2009.

“However, with multiyear drilling inventories already funded (and factored into company NAVs) it may be months or years before some companies focus on full-cycle returns, resulting in further downward pressure on prices in the near-term.”

With burgeoning natural gas production, observers must ponder how low prices can go. The Simmons & Co. analysts note that in a significantly oversupplied market in 2009, spot prices fell relative to coal prices sufficiently to encourage meaningful coal-to-gas switching. “Spot prices fell below $3 per MMBtu before producers felt enough pain to shut in sufficient volumes to balance the market,” according to the report, and the 12-month strip fell to $4.50 per MMBtu.

Also to be factored in are LNG dynamics. At current prices, major LNG producers report that natural gas liquid revenues associated with liquefaction plants can drive attractive returns even with gas net-back prices near zero, the report notes.