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Low gas prices may force producers to shift 'unsustainable' business model

By Brian Scheid

January 27 - Despite persistently low gas prices, US gas producers have made few changes to their overall business strategies, and some believe these companies in 2011 could begin to move toward a model that focuses more on return on capital, opposed to production growth.

Still, these analysts admit, it is a long shot.

"Producers don't really turn on a dime with their decisions," said James Crandell, an analyst with Barclays Capital. "They know prices can go low for a period of time and that's not going to kill them. But, when prices are sub-$4[/MMBtu] for three months, for six months, then they'll start to see more flow-through to lower revenues."

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Crandell said that if low prices are sustained for months, producers will first cut drilling before taking a more "drastic solution" such as changing their overall business model -- but that cut in production has not happened yet.

Baker Hughes last week reported a modest decline in the US gas rig count to 902 rigs as of January 14 from 914 rigs on January 7, but that number is still well above the 811 rigs the same time a year earlier.

Meanwhile, NYMEX gas futures prices have declined roughly 20% from a year ago. Last week, in its January Short-Term Energy Outlook, the Energy Information Administration lowered its 2011 average gas price to $4.14/MMBtu, down from previous expectations of $4.46/MMBtu. (See related chart: Closing prices for NYMEX Henry Hub gas futures contract)

While the rig count has fallen from a nearly 1,000-rig peak in August, Barclays said in a note to clients that it expects only a "modest drop" in drilling activity, In fact, the firm said it is possible producers could even increase the rig count this year.

In that same report, however, Barclays analysts argued that producers' current business model, focused almost exclusively on production growth, can only be sustained for so long.

"We have long argued that producers have a business model that shoots their product in the foot," the analysts wrote. "They desire high gas prices, yet individually seek to maximize production on a company-level basis."

The analysts also said that independent producers have been able to "get by" on hedges, borrowing and oil and liquids revenue. If these sources of alternative revenue dry up, a structural shift could be possible, they added.

"It is difficult to time when this could happen but the current producer business model looks unsustainable for dry gas producers in perpetuity," they wrote.

Ron Denhardt, vice president of natural gas services at Strategic Energy and Economic Research, said a shift to a return-on-capital business model is well underway in the coal industry, which for years was run mostly by engineers who sought new ways to expand production. Over the past five years, however, the industry has been overtaken by MBAs who have focused on consolidation and shifting priorities to emphasize adequate returns on investment over production increases.

"Will this happen in natural gas?" Denhardt said. "I don't know."

While some companies, such as Encana and Chesapeake Energy, have announced plans to cut back production and expenditures, it has not caught on among other producers, Denhardt said. This is at least partly due to conditions of lease agreements and joint venture agreements, which call for a set level of production over a period of time, forcing gas producers to see production as a sunk cost, he said. Additionally, Denhardt said producers could be holding out for future regulatory measures, such as restrictions on coal plants, which could boost demand and prices for gas. "There are some forces that set up an incentive to produce gas at a lower cost," he said.

Whatever happens, producers will have to shift their business model in some way, Crandell said. "The fact that so many of these producers are continuing to grow volumes into a weak market is troubling for the business model in our view," he said.

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