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Devon Energy CEO Expects Consolidation of Independent Natural Gas Producers – And Higher Gas Prices in 2011

August 20, 2010 | About:

John Richels who is the CEO of Devon Energy (NYSE:DVN) presented at the NAPE Expo conference in Houston on Wednesday. What I found interesting was why he expects a merger wave in the fairly near future. According to Richels the consolidation should already have happened, but has been deferred by a huge cash infusion from Wall Street which has allowed independent producers to continue drilling even as natural gas prices are low. Richels expects that the availability of this cash will soon end which will pressure debt laden producers to sell.

Another factor that has allowed these companies to keep drilling has been the hedges that were laid on during 2008 at much, much higher natural gas prices. Richels thinks that as these expire cash flows for the independent producers will drop and so will spending on new wells. Richels and company believes that as 2011 rolls around there will be a reduction in drilling which will lead to higher natural gas prices.

I would add that there is a third reason that will lead to a reduction in drilling. And that is that much of the Haynesville and other shale plays which were leased will be held by production in the next couple of years. Currently companies like Chesapeake Energy continue to drill aggressively in the Haynesville as they need to have producing wells completed on properties leased in 2008 or risk having those leaseholds expire. In other words they are drilling because they have to, not because they want to.

The old saying is that the best cure for lower gas prices is lower gas prices. And we will start to see this going forward. Chesapeake plans to make a large shift in its drilling capex to move from 90% natural gas drilling to a 50/50 split between gas and oil. Sandridge Energy is another which will go from being primarily a natural gas driller to over 80% oil drilling. It is going to take some time, but the market will address this oversupply.

Richels also went on to say that much of the current drilling for natural gas in the U.S. isn't profitable at current prices, as drilling costs for the natural gas and oil industry onshore the U.S. has significantly increased and that the trend is expected to continue.

Another well respected voice in the energy business is legendary figure Henry Groppe. Groppe has had a knack for correctly calling the oil market time and time again. Back in May he also predicted rising natural gas prices, here is recap of his thinking at that time:

Everyone thinks [shale gas] is going to solve all of our problems. There are very optimistic estimates about the economically recoverable volumes of gas from this new resource, he said in an interview last week in the Toronto offices of boutique fund manager Middlefield Capital Corp., where he's a long-time consultant and is special adviser to the nine-month-old Middlefield Groppe Tactical Energy mutual fund.

That's dominating everyone's views about the gas supply picture that we're going to be flooded with gas.

The reality, he argues, is that shale gas deposits are a tiny part of the North American production pool and they are already depleting fast.

Mr. Groppe says that while the average depletion rate in conventional gas wells is about 25 per cent (in other words, if you didn't drill at all for new wells, production would decline by a quarter each year), shale gas shows even more rapid depletion output tumbles, on average, 45 per cent in the first year for shale wells.

Drilling of shale plays has recovered rapidly from the slowdown during the recession indeed, the count of active horizontal drill rigs in the United States has ramped up to record levels which, because of the high initial production volumes that are characteristic of shale wells, has flooded the market with supplies and fuelled expectations of continued rapid growth. But given Mr. Groppe's depletion numbers, the high drilling pace may also be serving to drain the resource in the major shale pools even faster than they would otherwise.

As for the shorter-term supply picture, Mr. Groppe notes that for all that horizontal drilling frenzy, shale gas accounts for just 6 per cent of U.S. natural gas production.

In the other 94 per cent conventional gas the rig count is 70 per cent below the pre-financial-crisis levels of September, 2008, as low prices and high inventory levels have convinced producers to keep drills idled.

With that extraordinary drop in drilling, the [production] decline rate from all these [non-shale] sources is accelerating and will be much more than offset whatever increases you get in shale.

Add to that the fact that consumption continues to grow as the economy recovers, and he believes the glut in gas will prove strikingly short-lived.

We think that we're now having a continuous, rapid decline of gas in storage, he says. By summer, it could get to be alarming.

We would expect gas prices to get above $8 in the August-September range.

With natural gas now just over $4 Mr. Groppe is either early or wrong with his call.

As for me, I continue to sit on the sidelines unsure of when or if natural gas prices will recover. I have more conviction in $70 plus oil for years to come, and that is where I will focus my investment dollars.

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