The final quarter of 2004 should give U.S. oil and natural gas companies enough free cash flows and opportunities to fortify balance sheets and address operational deficiencies, according to a report issued Wednesday by Standard & Poor’s Ratings Services (S&P).

The report, “Record Pricing Driving Upswing in U.S. Oil and Gas Credit Quality,” noted that exploration and production (E&P) companies have benefited from a generally favorable pricing environment, but the final quarter of 2004 and early 2005 “appear to be a rarity: a perfect cycle in which all four segments (E&P, refining, drilling/services and petrochemicals) simultaneously will have strong profits.”

Weather will continue to play a role in either “stoking demand” or limiting supply. “On the supply side, hurricanes in the Gulf of Mexico (particularly Hurricane Ivan) have interrupted oil and natural gas production and played havoc with refinery supply chains, causing many refineries to reduce their runs during the critical heating oil supply-building season. On the demand side, October usually is a month of mild weather, but winter is lurking around the corner.”

The S&P report noted that gas inventories are currently about 7% above average and 6.4% more than a year ago. “More interestingly, demand for storage and available supply have been sufficiently strong to cause inventories to climb from 6% below average at the end of the heating season. Inventory pressure and the absence of hot weather pushed natural gas prices into the mid-to-high $4/MMBtu area. However, prices have since rebounded to more than $7/MMBtu on interruptions in supply from hurricanes, increasing manufacturing activity, concerns about adequate heating oil supplies and rocketing oil prices.”

“If inventory continues to climb in the absence of weather-related events or additional supply interruptions, natural gas prices may need to fall this autumn to clear markets,” said analyst Bruce Schwartz. “Gas prices in the short term may also become more sensitive to crude oil prices — if they fall — as residual fuel oil prices would likely become something of a floor.”

The gas market “appears to be somewhat better supplied now than in 2003 and prices have moderated,” but the supply constraints on gas “should not be underestimated.” Schwartz noted that low supplies are “likely to be more common than not for the next few years because North American producers at best are likely to achieve only very moderate (1-2%) production growth. Material increases in liquefied natural gas (LNG) imports appear unlikely until 2007, when additional LNG receiving terminals and tankers will likely enter service.”

The S&P report said that E&Ps still face critical issues, despite strong operating cash flow. “Merely generating such cash is not the sole requirement for a ratings upgrade; companies must use the free cash flow for sustainably improving their business and financial profiles.” And Schwartz said it is still possible for E&Ps to be downgraded.

“The principal issues confronting E&P companies are depletion — particularly for North American natural gas — cost-containment, merger and acquisition activity, reserve revision risks and sovereign risks.” Strong discretionary cash flow could provide an impetus for companies to deleverage in the final part of this year, but S&P is “concerned that debt leverage could actually rise in the near term as companies turn to mergers and acquisitions (M&A) to counter accelerating depletion rates (which have not been helped by inconsistent results from certain coalbed methane and deep-shelf gas plays) and continue growth in reserves and production per share, which are key equity valuation metrics.”

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