Collapsing gas market fundamentals recently drove both October Nymex gas futures and Henry Hub spot gas prices to four-year lows, well below the average economic threshold price-based on a projected pretax internal rate of return of 20%-identified in 25 prominent gas resource plays.

However, with a median threshold price of $5.40, virtually all of these plays generate attractive economics at current 2007 futures prices ($8.27), and roughly three-quarters of the plays yield attractive economics using a long-term price forecast of $6.25. The best plays (Jonah/Pinedale, the core Barnett Shale and the East Texas Freestone) generate attractive returns even assuming a $4 Nymex price and current costs, while lower-return plays typically occur in less prolific Rocky Mountain basins currently beset by gas-on-gas competition and wide basis differentials.

Based on recent realized Rocky Mountain prices in the $3 to $4 range and current cost structures, few projects, aside from Pinedale in southwestern Wyoming, are capable of generating adequate returns in the region. Most plays, however, generate acceptable well economics based on a long-term gas-price forecast of $6.25. For example, a typical Mesaverde well in Utah's Natural Buttes Field has an internal rate of return of 25% at $6.25 and realized price of $5.25. The IRR jumps to 40% on the recent 12-month strip of about $7.73 held constant for the life of a well. Most capital-spending decisions will hinge on the latter figure. Therefore, if the 12-month Nymex strip sags below $5.50, anticipate capital spending cuts in virtually all of the gas plays in Utah's Uinta and western Colorado's Piceance basins, where more than 100 rigs are actively drilling.

Across all 25 plays, the vast majority of independents currently indicate no intention of slowing drilling programs, insisting the recent price slide is an artifact of high storage levels following an abnormally warm winter, a view supported by the strong futures price contango and short-term curtailments recently announced by two large producers (Chesapeake and Questar). This is in stark contrast to mid-2001, when producers responded to a structurally over-supplied market by severely reducing drilling far in advance of price bottoms and production shut-ins.

Given high storage levels and struggling supply growth, winter weather demand is expected to have the greatest impact on both gas prices and U.S. drilling budgets in 2007. In the most bearish scenario, a much warmer-than-normal winter, or even a slow start to the season, could cause the 12-month strip, which has declined 12% since September 1 to $7.73, to fall another 20% or more and prompt significant cutbacks to 2007 capital expenditures.

Markets are already discounting a much warmer-than-normal winter, so any near-normal weather should cause a strong rebound in both gas prices and equities. Although this will only become apparent as winter unfolds, it is a good time to selectively invest in companies with meaningful exposure to higher-return plays and robust near-term hedge protection, including XTO Energy, Southwestern Energy and Quicksilver Resources.



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