Hiking through the macroeconomic forest of natural gas trends makes independent producers want to cast more breadcrumbs, to find their way back to safety. In recent weeks, the gas-rig count has tumbled in response to the new economics of weaker prices-but that news may not be all bad. Analysts have suggested that the last 200 or 300 rigs drilling as the count reached it zenith this past July were mostly poking holes in mediocre gas prospects-that was all that was left from the gas-drilling surge of 2000-01. Despite some near-term doom and gloom about overly full storage, low prices and flat production, analysts at Morgan Keegan & Co. think the worst of times may already be over. "Gas fundamentals may turn bullish during the early part of next year," say Subash Chandra and Donatello Pitts, E&P analysts in the firm's Houston office. "Production falling faster than anticipated will abbreviate the price decline." They think gas prices will end up averaging $3.91 per thousand cubic feet this year and $2.75 per Mcf next year. In any case, the economics of gas drilling have worsened and producer sentiment has changed. Cash flows began falling in lock step with gas price declines-in some parts of the Rockies, spot gas prices went below $2 per Mcf in October and November. Drilling in the Gulf of Mexico on the Outer Continental Shelf in shallow water fell precipitously. At press time, Nymex prices had recovered to a bit above $3 for the near months and remained above $3 for delivery next summer. Many analysts foresee gas prices averaging $2.50 to $3 next year. Some cite full storage as a factor pulling prices down. In July, the amount of working gas in storage surpassed the five-year average and it continued rising every week thereafter. (See sidebar.) By November 1, the traditional start of the heating season, U.S. storage had reached 3,091 billion cubic feet, some 8% above the five-year average and only 1% from its all-time high. Rigs versus output Despite this apparent abundance of gas, pundits continue to worry about the true nature of long-term gas supply. The minimum average annual U.S. gas-rig count required to replace production-not increase it-is about 800, according to Greg McMichael, E&P analyst with A.G. Edwards & Sons in Denver. "If the count should fall below that...supply and demand could tighten significantly in 2002, depending on the timing of economic recovery and the number of rigs operating in the first half of the year. As recent history suggests, a record gas rig count [900 to 1,000] only generates a 2% to 3% increase in production, so seeds of another cycle similar to 2000 may be sewn during the next three to six months," he says. Baker Hughes Inc.'s U.S. gas-rig count peaked in July at 1,068 but by October 26, had fallen below 900 for the first time in many months, to 876, or 18% off the high. By November 2 it had dipped to 838. When E&P companies reported their third-quarter results, gas production for many was flat or down (discounting the effects of mergers and acquisitions). Merrill Lynch's John Herrlin points to adjusted production for 22 companies, including 14 independents. Overall, their gas production fell 2.4% from the third quarter a year earlier, and was down 2.9% sequentially from the second quarter of this year. Meanwhile, McMichael points to 25 of the top 27 U.S. gas producers, which account for roughly half of total U.S. production of 52 Bcf per day. After adjustment for acquisitions, their gas output declined 1.2% from the second quarter and 0.4% from the prior year, despite a lot of drilling. "While preliminary, this listless response to a record gas rig count of 950 in the first half suggests U.S. gas production may be rolling over sooner than expected," he says. "If the rig count continues to fall, as we believe it will, the delicate balance between supply and demand could change dramatically in 2002," which is bullish for gas prices. Demand The events of September 11 have pushed back a hoped-for economic recovery. The Natural Gas Supply Association (NGSA) contracted with Energy Ventures Analysis Inc. of Arlington, Virginia, to study the trends. The latter indicates that, assuming a 10% decline in industrial output, overall natural gas demand will be 2.1% lower than last year. McMichael estimates that this year, industrial demand dropped 2- to 3 billion cubic feet per day from last year, yet gas production was running about 1 Bcf per day higher (a 3% increase), thus creating the storage glut. "Industrial gas demand, which accounts for 40% of total U.S. gas demand, is off 7% to 8% year-over-year. An absence of significant weather-related demand...could put downward pressure on prices and E&P stocks," McMichael and his A.G. Edwards colleagues report. Macroeconomic factors do not signal that demand will be picking up any time soon. The U.S. gross domestic product fell 0.4% in the third quarter, the worst performance in years, presaging the official or statistical start to a recession. Many economists now say the economy won't turn north until third-quarter 2002-at the earliest. A flurry of cold weather forecasts that were released in October for the coming winter prompted a brief rally in Nymex gas prices. Still, the skeptics rule these days. "The issue for the industry is more than just weather," notes Herrlin. "With the gas-rig count down about 15% from its high and heading lower, and 2002 capital-expenditure plans expected to be down 20% [proportionate to cash flow], U.S. dry-gas capacity should diminish 1% to 3%, even with the new deepwater Gulf of Mexico projects." Andrew Lees at Stifel Nicholas in Denver sees nothing that would increase annual average gas prices beyond his current assumption of $3 in 2002, unless there is a hard winter. He foresees an average of $2.75 in the first half, with the price rising to $3.50 by year-end 2002. No one is suggesting gas prices will peak at $8 or $10 per Mcf as they did last winter. Those high prices left American industry no choice but to cut its gas usage meaningfully, proving once again that demand is never assured in a rising price environment.