Oil in for strong recovery; gas to maintain $5

Oil is poised for a strong and long-term recovery, while gas will hover at current rates, says Marshall Adkins, Managing Director for Oilfield Services at Raymond James & Associates.

 Adkins forecasts that oil prices will move steadily higher with prices averaging more than $100 over the next five years on very strong fundamentals. However, the oil to gas price disconnect will continue for at least the next 3 years and as much as 5 years with gas prices averaging $5 mcf—but $5 gas, he says, is not a disaster.

Demand Drives Oil

 The international side of the industry is driven by oil, he says. Historically, analysts consulted oil inventories for pricing data, but that correlation has fallen apart. Crude prices today are driven by demand.

“As demand started to get ‘less worse,’ we saw prices rally with the demand side,” says Adkins. “There’s no doubt demand will be important in the long term—oil demand in the developed world has to go down to accommodate the developing world. China and India will be the key drivers.”

 Non-OPEC supply declines will be a bigger driver of oil prices in the next few years. 

“In the first part of the decade we had phenomenal growth in non-OPEC, but now the direction is clearly down and will continue moving forward,” he says. “We are right at the point of peaking non-OPEC crude supply. By our numbers, in late 2009 or early 2010 we will have had absolute non-OPEC production peaking.”

The key driver is Russia. They had rapid growth the first half of the decade, declined in 2008, bounced up again in 2009, and likely will be up slightly this year, says Adkins.

“In 2011 and beyond we think Russia will begin to see a gradual decline in their production,” he says. “Russia is facing what the U.S. faced in the 1970s, where we had 4,000 rigs drilling, spending was up 20 fold, and production still fell by 35 percent.”

 If Russia is left in decline, then the only growing non-OPEC countries will be Brazil, Canada, and the Caspian. He says that OPEC has done a great job of managing around demand decline by cutting productions and maintaining prices. Moving forward, the market will focus on excess capacity. However, Adkins feels that OPEC’s stated excess capacity is largely an exaggeration—for example Venezuela claims 200,000 bpd surplus.

“If you haircut the stated capacity with what I think is the real world, you get down to a little less than 3 million barrels of excess capacity,” he says. “If demand returns to historical levels, which it appears to be doing, you get demand growth of 1.5 million to 2 million barrels per day each year. If you get no growth in OPEC, in two years you’re done and we’ll have a shortage of crude again.”

Overall, Adkins says that forecasting oil is fairly simple.

“Prices will move higher based on deteriorating non-OPEC supply and falling excess OPEC capacity,” he says. “The market must eventually ration available oil by price, and that will begin within 2 to 3 years.”

Natural Gas

The industry has shown that U.S. supply can grow at $5 mcf, so there’s not a lot of reason to be above $5, says Adkins. In addition, LNG imports will surge above $5 mcf as will gas to coal switching for utilities.  The reason is shale gas—the game has changed.

“I was a permabull for a decade because supply was falling,” he says. “Now supply is up sharply in the shales. Barnett wells were twice as productive in 2006 as an average well, then three times as productive in 2007. And Haynesville wells are 10 times more productive.”

 He says that the industry will see an expansion of horizontal drilling into all types of reservoirs.

 “Private operators in the past nine months have gone from 20 percent horizontal drilling to 50 percent,” he says. “The economics are much better and the shift is here to stay.”

He added that while horizontal drilling is what everyone talks about, other things drive lower cost. There was substantial high-grading in the market—the rig count is 30 percent lower, so Adkins theorizes that the industry simply got rid of 30 percent of the worst wells.

“Service costs are also down 30 percent, and drilling efficiencies are about 20 percent faster,” he says. “Now you have wells that once took an $8 price to drill, now takes $4.”

He says that a lot of companies are making money at $5 gas, and rig count is up 65 percent.

“So why are companies drilling in a $4 world? It’s the oily gas plays,” he says. “Pioneer had 20 mcf a day of gas and 2,000 barrels of crude condensate, so it works economically.” 

The U.S. has seen a huge increase in LNG import capacity. The country can bring in 15 bcf per day, but Adkins says it won’t happen because there isn’t enough supply.

“When we net out global supply and demand issues for LNG, we think we’ll have a net 3 bcf per day more gas in the system than last year, and maybe a 1 to 1.5 bcf per day will come here,” he says. “There will be an increase in LNG but it will be price sensitive—we think gas will be $4.25 this year and $3.50 in the heat of the summer. If gas were $6, it would be 3 to 4 bcf per day.”

Demand also is picking up—industrial demand has added .5 bcf per day with the same increase in utilities.

“Coal to gas switching accounted for about 2 bcf per day more demand last year, and if it goes above $5, it will switch back,” he says. 

Finally, he says that the U.S. average rig count will move higher in 2010, although it will peak near May. The industry will not need 2,000 rigs for some time.