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Producers Advised to Reinvent the Business

Producers Advised to Reinvent the Business

The only thing John Olson, senior energy analyst for Sanders Morris and Mundy, needed last week following his speech at a producers' conference on gas supply and demand at the Canadian embassy in Washington, D.C., was a producer to volunteer to step up on stage and be slapped around.

If there was even a smidgen of doubt that producers are headed in the wrong direction following a quarter with huge financial losses, Olson clearly erased it. His speech, titled "Gas Supply? What Gas Supply?" sounded like a half-hour tirade by a teacher handing out Fs to the entire class.

"I am like the fox in the hen house," he said. "I want to show you what Wall Street is really looking for out there," and it's clearly the opposite of what you're doing.

Olson noted the industry is in "crisis mode," has been since last November, and probably will stay "in the ditch" for some time. It's time for some significant changes to take place.

The average E&ampP stock price was down 41% in 1998. The average producer earned nothing and may do the same in 1999. There were billions of dollars in year-end ceiling test write-downs on producing assets. In fact, many producers now are working for the banks, selling off assets to pay down notes. Most production is unhedged and not flowing under long-term contracts. U.S. producers have lost 14% of the domestic gas market to Canadian producers. Drilling budgets for 1999 are down 25-30% at a time when well decline rates are 5-20%/year. To top it all off, 50,000-75,000 out of a total of 477,000 stripper wells are being shut in, possibly for good.

"I don't mean to be overly negative," he said, insisting he's "bullish on this business. But it depends on how you reinvent the system over time." The industry cannot stay on the path that it currently is on because it diverges so completely from the direction everyone-including Wall Street, the government and consumers- - expects it to follow.

The government is expecting 3% annual growth in production and 27 Tcf/year in gas production by 2020 from only 19 Tcf last year. "I don't have a clue where you are going to get [another] 8 Tcf/year," said Olson.

Anadarko Vice President Richard J. Sharples spent half his speech detailing the sharp production declines in nearly every major Mid-Continent and Gulf Coast producing area and he held out little hope that the deep-water area of the Gulf of Mexico would be the savior of lower-48 production. He agreed this is a time of crisis, but Sharples was somewhat more confident than Olson that the industry could overcome its problems without fundamental changes.

"This is a call to arms to producers, although they probably don't need another call to arms after cost management actions they've already undertaken to get through this period," said Sharples, noting the thousands in staff reductions and $160 billion in mergers that took place in 1998. "But there are significant regulatory and legislative actions that can impact our ability to come out of this period and add to a strong healthy industry and fuel the gas demand growth that we'd all like to fuel.

"[This] is a request that energy policy makers carefully weigh the potential impacts of their actions on the viability of the U.S. energy industry." He mentioned the need for federal action allowing producers to pay the government royalties in-kind (in production), moving electric restructuring legislation, lifting the offshore moratorium and easing the tax burden. He also mentioned the Federal Energy Regulatory Commission's various notices of proposed rulemaking and inquiry as potentially helpful to producers.

Producers can't expect the government to do the job, according to Olson. They have to reinvent the business themselves, including doing away with the traditional "netback model," where producers live "hand-to-mouth in the spot markets, taking whatever prices are left over in the value chain." Part of the reason the Canadian producers have been able to capture 14% of the U.S. market from only 6% in 1986 was their willingness to sign long-term agreements with Northeast cogenerators. U.S. producers have something to learn from that. And more buyers seem eager to help them by offering to prepay long-term agreements.

"You have to protect yourselves in situations like this," he said. "That's what Wall Street is really looking for:" companies with locked in long-term contracts and hedged production. He called on producers to "maximize contract bullet proofing [with more] indexing, swaps and rolling hedges."

Another key strategy for the future for producers will be to capture more of the value chain, said Olson. Move mid- and downstream. Invest in cogens. "You may be in the wrong business or you may not be in all of the businesses you should be in." There couldn't be a better time for a producers to invest in the gas-fired power business and sign-more long-term agreements with end-use markets, particularly power generation, he said. "That's where the money is, ladies and gentlemen."

The Department of Energy is forecasting the need for 383 gigawatts of total new power generating capacity by 2020 and 90% of that will be gas-fired. Even being very conservative, that translates into 16 Bcf/d of incremental gas demand. "This is where the E&ampP industry is likely to have its best and brightest hope to make a massive comeback over the next 10-12 years," said Olson. Power plant developers "need you more than you need them. You may be down at rock bottom with a smile on your face and a shine on your shoe, but they need you.

"I think this is going to be the engine that drives the whole train of the North American exploration and production industry. There's nothing else out there that can do it."

Olson's "1999 Unofficial Game Plan" for independent producers, many of whom he says probably won't be around much longer, includes the following:

Either

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