2011 to be a bull market for oil, bear for gas

Much like 2010, the oil and gas markets will be a mixed bag for 2011, says Collin Gerry, an analyst with Raymond James and Associates.

 Oil will be shaky in the short term and bullish for the long term, while natural gas is bad in the short term and questionable for the long term.

“For oil in the near term, markets will go up and down on nearly anything happening around the world—we call it headline risk,” says Gerry. “In the long term, demand looks solid and supply looks constrained, while the exact opposite is true for gas.”

 Oil will be the driver for the industry and the rig count will remain strong.

Oil Forecast

Analysts generally look at U.S. oil inventories as a proxy for oil price performance—low inventories mean higher prices and high inventories mean lower prices. However, today the U.S. has very high inventories, yet prices are still strong.

The reason is there has been a reversal in oil price versus the broader market. The two were historically at odds because an increase in oil price is essentially a tax on the consumer.

“The stock market now drives oil, which I think is recognition that we’re going to be in a tight oil market,” he says. “People depend on the broader market to forecast the economy, and if it’s good, we’ll need more oil.”

Demand for 2010 increased by 2.7 percent. By comparison, the decade averaged  2 percent annual increase and dipped 1.5 percent for the recession. Virtually all growth came from emerging economies.

“This isn’t sustainable and we think there will be a 1.5 percent increase in demand for 2011, which equates to 1.3 million barrels a day of incremental demand.  For any country to move up in terms of industrialization, it has to come at the expense of the developed world, and the balancing mechanism is price.”

The supply side, says Gerry, is a critical piece for being bullish. Non-OPEC represents two-thirds of world supply; and two-thirds of that number are from mature or declining fields. At the beginning of the decade, non-OPEC grew 750,000 to 1 million barrels per day each year.

“Now non-OPEC supply is going down. The earlier part of the decade was nearly all Russia, producing the easy stuff from the fall of communism and re-developing old fields,” he says. “Now we see greenfield investment, so Russia is tapering off. There are big fields coming online in the next few years that might support their numbers better, but long term it looks like a repeat of the U.S. hitting the decline curve wall in the 1970s.”

The U.S. drilling moratorium had a greater effect than expected. In 2009, the U.S. produced an incremental increase of 400,000 barrels a day; 2010 was forecast to be a further increase of 500,000.

“Now we predict a decrease of 300,000 barrels a day, which means we have a year-over-year swing of 800,000 barrels a day,” he says. “Our position is that we need to get back to work fast.”

OPEC’s productive capacity is key to the oil model.

“OPEC says that they have 6 million barrels a day in excess capacity. We don’t think so,” he says. “Iran, Nigeria, Venezuela, and Saudi overstate, and we think the excess is less than 3 million barrels a day. If that’s true, and oil demand is an incremental 1.3 million barrels, and non-OPEC declining, then we’re out of oil in 2 to 5 years.”

Finally, he says that Iraq does not affect the oil model because their numbers are untrue.

“They say that by the end of the decade they can produce 12 million barrels a day, which would make them the world’s largest producer,” he says. “Their peak was under 4 million in the late 1970s when they had access to western technology and non-depleted fields. We think they can achieve 4 to 5 million per day in this decade if everything runs smoothly.”

Gas Forecast

The U.S. has far too much gas at $5 Mcf pricing, so the market needs lower prices, says Gerry.

“Supply can grow substantially at $5, that has been proven,” he says. “LNG becomes a problem at $5, and gas to coal switching will occur at $5. The next few years, barring a meaningful drilling decrease, look ugly for natural gas.”

In 2011, Gerry says that the U.S. will increase supply by 3 Bcf per day or more. The rest of the world is increasing supply as well—scheduled natural gas
liquefaction projects will increase supply by more than 5 Bcf per day in 2010 and more than 3 Bcf per day in 2011.

On the positive side, industrial demand is coming back. It peaked in 2002 at more than 20 Bcf per day and by 2012 usage is expected to be more than 19 Bcf per day. Gas prices are now low enough to compete with coal, which drives an increase in demand for gas. Also, Gerry adds, the U.S. is shipping coal to China, which increases the coal price floor.

Raymond James’ gas model places an emphasis on storage.

“Capacity is about 3.9 Tcf, and we predict about 4.25 Tcf—that’s a problem and gas prices will crater as we exit summer,” he says. “We have bearish sub items like coal to gas switching and industrial demand, but the oversupply is huge.”

Drilling Forecast

Natural gas based drilling activity will continue to taper off, especially on conventional plays. But, the industry will double rig counts in the Bakken and other liquids rich plays.

“We think rig count will be up 5 to 10 percent next year, which is about 1,750 rigs,” he says. “So why drill now? We have hedging, holding leases, pre-funded programs, oily gas plays are surging, and some gas plays work at $4, such as the Marcellus.”

The horizontal rig count is quickly climbing. In 2005 they were 10 percent of the market, now it’s 55 percent and it will continue to rise.

“The higher oil rig count will offset lower gas rig counts,” he says. “Historically, we’ve had ten percent of the rigs drilling for oil and the rest drilling for gas; in two years that will switch to a majority drilling for oil.”

In deepwater, Gerry sees little improvement. Though the moratorium was lifted, permits are not being issued.

“It’s bad and getting worse—operators are spinning their wheels trying to figure out what will satisfy the government,” he says. “Nobody knows what to do on either side. Prior to the moratorium we had about 25 deepwater rigs, set to go to 45 by 2012 because we were finding a lot of oil. Now we forecast 20 or 25 rigs by 2012.”