A Comprehensive Review of the E&Ps in 2006
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Gas Prices Slid, Oil Prices Rose in 2006. WTI oil prices rose 17% in 2006 to
average $66.21 per Bbl owing to a tightening gasoline market and weak non-
OPEC supply growth. NYMEX natural gas prices averaged $7.22 per MMBtu in
2006, down 17% from 2005 levels (the first fall since 2002). Natural gas prices
fell throughout the year on evidence of supply growth and industrial demand
losses after the late-2005 hurricane-related price spike.
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E&P Stocks Lagged in 2006. E&P shares fell 2% on average in 2006 after
posting a 44% gain in 2005. Share performance was challenged by
narrowing margins due to higher costs and falling gas prices. Unit reserve
valuations averaged $3.13 per Mcfe in 2006, up 14% compared with $2.75
per Mcfe in 2005. We estimate the group is currently trading at $2.71 per
Mcfe on 2006 reserves. Based on our net asset value estimates, we factor
the stocks are currently discounting $55.00 per Bbl oil and $7.25 per
MMBtu gas, which is up from $45 per Bbl and $7.00 per MMBtu at this time
last year.
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Drilling Activity Surged. The U.S. rig count rose 19% in 2006, peaking at
1,762 (in mid-August) as producers continued to accelerate spending
despite falling gas prices. Capital budgets rose 86% in 2006 to $103 billion
as producers pursued growth through the drill-bit (organic spending up
45%) and M&A values surged (acquisition spending up 141%). Onshore
supply growth was robust (+4.5% in 2006) and played a significant role in
the gas market decline. E&Ps spent some 120% of generated cash flows in
2006, an unsustainable trend, and we are likewise witnessing moderation in
spending growth.
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F&D Costs Rose 42% in 2006. All-in F&D costs rose 42% to an average
$3.34 per Mcfe ($20.02 per BOE), up a staggering 86% from 2005. Organic
F&D costs rose 17% in 2006 to $2.95 per Mcfe ($17.71 per Boe). Cash
operating costs rose 16% in 2006. The capital and operating cost inflation is
largely due to the industry’s focus on smaller unconventional gas
reservoirs. Although service and drilling costs have moderated, we think the
secular component of cost inflation is still rising at double-digit rates.
Likewise, we think drill-bit F&D costs could rise again to above the $3.00
per Mcfe mark in 2007.
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Margins Were Squeezed. With F&D and cash costs on the rise and gas
prices falling, E&P operating margins narrowed 13% in 2006 to $3.15 per
Mcfe. For 2007, we forecast operating margins will fall another 13% to
$2.75 per Mcfe (at $61.40 oil and $7.25 gas). We now estimate the breakeven
price needed to earn a 10% after-tax rate of return is $7.55 per
MMBtu (based on Q406 costs). Likewise, we recently raised our price
forecasts (March 20), as the economic cost curve should support $7.50 per
MMBtu pricing through 2010.

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