Falling natural gas prices coupled with rising stock prices for gas-focused E&P companies have investors perplexed. With the drilling rig count in a freefall earlier this year, expectations were that gas production would soon be falling and gas prices rising. Neither expectation has come to pass – yet. Contrary to conventional wisdom, natural gas production has not fallen. In fact it has remained remarkably stable despite gas-oriented drilling being cut in half. The latest EIA Form 914 supply data showed gas production in June increased 0.5 Bcf/d from May’s initial estimate, bringing production back in line with the monthly averages experienced since late last year. How can this be? From the bottom in the U.S. rig count – the week of June 12th according to Baker Hughes, the overall count is up 14%. Measured from the same point, the oil rig count has advanced 56% while the gas count is only 2% ahead of where it was 11 weeks ago. At the same time, crude oil prices have climbed above $70 a barrel and even challenged the $75 price level recently, while natural gas prices have dropped steadily to under $3 currently. With physical gas prices well below the NYMEX price, commodity trader technicians point to $2 as the next real price support level. Against this backdrop, why are E&P stock prices rising? Some investors say that since the stock market always looks forward, it is discounting the current low-price environment and predicting higher future gas prices and, correspondingly, higher future earnings for gas producers, especially for those companies that can grow their reserves and production. Others suggest that investors are being forced to play the gas price recovery theory through its first derivative – E&P producer stocks – out of fear of gas futures trading restrictions being tightened by the Commodities Futures Trading Commission. Once scenario being discounted by the stock market’s action is a repeat of the 1980s and 1990s when gas prices remained about $2 throughout due to a surplus of supply and a lack of demand. Those market conditions are similar to the current environment. Unless gas demand recovers soon it is likely we will approach full storage capacity putting further downward pressure on prices until winter arrives. A mild winter could create serious pricing problems for natural gas in 2010. In the meantime, gas producers, who have enjoyed the cash flow from hedging contracts entered into in the past at prices that are multiples of today’s prices, are facing the prospect for a return to reality when these hedges expire. There is an estimated $67 billion of E&P producer debt due to mature in the next three years, and many producers will soon be facing their bankers in renegotiations of existing lines of credit. While risk tolerance in the credit market has improved somewhat, banks don’t want to be facing energy loan problems while also dealing with troubled residential and commercial real estate loans. Low gas prices and their impact on producer finances will become a contentious issue between the parties. Those renegotiations may be further challenged by reserve estimation problems if the recent research by Art Berman has validity. His work suggests that the economic ultimate recovery of many of the gas-shale wells is well below the reserves producers are booking. This means well profitability is being overstated. With potential reserve write-downs in the future, shaky production economics and inflated balance sheets, it is beginning to look like we might experience another episode in which the E&P industry destroys more capital than it creates. So far, no producers have taken up the gauntlet Mr. Berman has thrown down in his analysis, probably because no one wants to be perceived as the Emperor with no clothes. The bigger issue may be that the big industry push to elevate natural gas from an afterthought into a role as the fuel to bridge this country’s transition from one energy age to the next could be jeopardized. The industry needs increased demand in order to attain higher gas prices. The Potential Gas Committee says the U.S. has 1,836 trillion cubic feet of gas reserves, of which fully one-third comes from the gas-shales. The potential reserves are the highest the Committee has recorded in its 44-year history and these reserves insure a longer gas production life than previously perceived. However, it is a giant step from technically recoverable gas reserves to economically producible ones. Here’s hoping that gas prices rise enabling producers to expand profits with these gas-shales, but the history of capital stewardship by the E&P industry is not encouraging. G. Allen Brooks, Parks Paton Hoepfl & Brown