Oil and gas are moving in opposite directions right now – oil up and gas down. Oil stocks are tepidly advancing, not quite convinced the move in the oil price is sustainable.  Natural gas stocks -those not already crushed – I fear are getting ready for a further 20-30% decline as the next down leg in natural gas prices have begun.

OIL

Colleague Richard Reinhard and I postulated last week that Canadian listed oil stocks would start to rise as sentiment was looking for any excuse to rally oil, and that the US dollar would remain strong and stronger as long as the equity markets were under pressure – and this is happening. 

With the US$ now at $1.30 CAD, and oil at US$47/barrel, the Canadian producers’ oil price is $61.10. Many producers make money at that price – making the recent sell off in oil stocks overdone.  Some of the really low cost producers who have a lot of horizontal wells (see one of my original stories on this breakthrough technology that greatly increases production and lowers costs) have costs of CAD$30/barrel in the prolific Bakken oil play of Saskatchewan.

Bulls are making much of the fact that the oil price is rising while the Dow Jones Industrial Average continues to fall 50-100 points per day.  Two bullish statistics were that investors saw oil inventories decline for the first time in several weeks last week, and the EIA (Energy Information Administration in the US) reported that gasoline use actually increased in the last week of January, year over year – only 0.8%, but an increase nonetheless. 

I am not convinced oil is ready to break out of its trading range. Investor sentiment is fragile – one bad week of oil inventory build up could see prices and stocks tumble.  I suspect this is a tradable rally but continuing rise in unemployment will put a lid on demand, and I see oil making one more trip down to the bottom of its trading channel before the massive global stimulus packages and rock bottom interest rates make oil break out.

But I have done some research and actually prepared reports on several junior/intermediate oil companies (and one gas, believe it or not) which I will now update and post to the website one at a time over the coming weeks.  They are not to be construed as stocks I am buying.  But it will give readers and prospective subscribers a sense of what they will receive each month.

NATURAL GAS

There are only a few natural gas producers whose stocks are still standing relatively strong – companies like Storm Energy (SEO-TSX; $9.88), Progress Energy (PRQ-TSX: $7.83), Celtic Energy (CLT-TSX; $12.35).

Natural gas now sells for under $4/mcf in both Canada and the US, and I see it moving lower through the spring and summer. Most investors will be surprised how low natural gas prices will go – some of the industry publications I read have had speakers calling for sub $2 gas, and one went so far to say that gas will go to zero- no bid – for a time.  This evidently happened in 2002.

The Canadian natural gas stocks have now had all their good news come out.   All their 2008 year end numbers were excellent, due to the great prices they enjoyed for the first nine months.  Their yearend reserves were up because of all the successful horizontal drilling they did on these huge new gas plays in Alberta and B.C.  Those that could raise equity to lower their debt level, have.

I see no more good news for natural gas stocks.  Prices are low and going lower.  The market is now watching LNG (liquid natural gas) come across from as far away as Australia to the Atlantic Ocean for sale – to either Europe or North America.

The big 3 I just mentioned have strong institutional support, so they will probably only decline 20-30% from here, and be the first to bounce back. (Despite raising equity, they still have debt levels close to their maximum allowable). I suspect even the most beat up junior natural gas stock still has A LOT of downside in it. Positive cash flows through Q2 and Q3 this year will be anaemic to zero.

In fact, the world is so universally bearish on natural gas a contrarian should be intrigued.  For the masochistic gamblers among our readers, have a read of this research piece from First Energy.  They are one of the top oil and gas boutique brokerage firms in Calgary specializing solely on energy:

http://www.firstenergy.com/research/documents/Facts-I-GasSpringFling-2009-02-19.pdf

Lastly, I want to point investors to a recent well by Celtic Exploration that epitomizes the new long term price structure on gas.

They have a land position in the Montney play, one of the most high profile but low cost Canadian shale gas plays.  The industry is quickly turning the Montney formation into Swiss cheese using horizontal drilling – and it’s very effective. 

Now, after you DRILL a hole, you have to FRAC it, which is sending a very specific type of fluid down the hole at super-high pressure, out into the surrounding rock to break it up so the oil can flow into the well.  It is this new, MULTI-STAGE FRACING that has allowed the industry to develop these huge pools of natural gas that have been known for decades.

Celtic recently drilled a successful well using 11-stage fractures with initial production rates of up to 14.6MMcf/d.  That is a HUGE well – 1 MMcf/d is a big well!  BMO Nesbitt estimates in a report on Celtic that well will break even at $3/mcf gas and have the industry required 10% IRR (internal rate of return) at $3.65 gas. 

Over time, the price of natural gas (or any commodity really) trades for just above its cost of production. There will be price peaks like last summer and troughs like right now, but generally that’s the case.  With horizontal drilling, huge new reserves of natural gas are being opened up, and the horizontal wells produce so much more gas than the old vertical wells that the cost base for this gas will now be a lot lower. 

If gas can be profitably produced for $3.65/mcf, and huge new reserves are being opened up, then we will see the price of natural gas be a bit above that.

Not every well will be close to that big or profitable.  But a lot of the new HD wells that are being drilled all across North America unlocking large new gas pools do have higher than average historical production, and are low cost producers.  These wells do see declines of up to 50-60% in the first year, then 25% or so annually afterwards.

It’s difficult to see how prices could ever get back to double digits – even $7/mcf gas – in the near future.  But the good news is that even at $5 gas, there will be many profitable gas companies using HD technology.