Higher operating costs, combined with a decline in natural gas prices, led Calgary-based Compton Petroleum Corp. last week to slash its spending and reduce its drilling program for the rest of the year. Compton also said it would sell some noncore assets, estimated to be worth about C$100 million, and would consider selling off its major conventional oil properties to focus more on resource plays. The announcement led some energy analysts to believe smaller producers like Compton could become acquisition targets.

Compton, which earlier this year was named one of energy consultant John S. Herold’s top exploration and production value creators (see Daily GPI, Jan. 27), on Wednesday reduced its budget almost 20% to C$465 million from C$575 million, mostly on reduced drilling and completion costs related to its shallow gas program in southern Alberta in the Western Canadian Sedimentary Basin (WCSB) and crude oil operations. Cash flow from operations is now expected to range between C$325 million and C$345 million, a drop from previous guidance of C$375-400 million.

In a note to clients, Octagon Capital analyst Jeffery Fiell said the spending cuts will reduce Compton’s production by about 8%. With lower gas prices, Fiell said some of the smaller gas producers are now attractive targets. Unlike the oil producers, which are making a lot of money, “we expect to see a lot of merger and acquisition (M&A) activity in the near future” among gas producers, Fiell said. “There’s currently a value disconnect between oil and gas.”

About 20 gas producers in Western Canada could be involved in some type of takeover by the end of the year as they are squeezed financially, Fiell said.

“They’ve been spending capital on drilling and oil and gas activities as though the price was high,” Fiell said. “If your spending is up and your cash flow is down, your debt is going to go up.”

Although he expects Canadian producers to become merger partners, Fiell also suspects that U.S. producers may “come in opportunistically.”

Canaccord Adams energy analyst Terry Peters also believes industry conditions point to more M&A, but he also noted that there is still a lot of money being made, regardless of lower gas prices.

“Anytime there’s a disconnect between share valuations and commodity outlook, you get that opportunity,” Peters said. “Certainly gas producers had expectations of higher cash flow and growth going into this year that many of them are not going to realize. And capital markets are weak in general, so funding alternatives become a challenge.” But Peters added, “I don’t think any gas company is not making money at these prices.”

EnCana Corp. CEO Randy Eresman said in June that “there’s certainly a number of indications that companies are cutting back on their programs.” Speaking at an energy conference last month, Eresman said, “they simply don’t have the same level of capital available to them as they had before.”

Earlier this year, EnCana announced it would trim its spending by 12% or $800 million to control rising costs. Eresman said the lower gas prices are expected for the near term, but he still doesn’t expect his company to increase its spending program.

“There’s a separate question on whether or not you want to actually produce into the market or tying-in as aggressively as you were before,” said Eresman. “There’s still some advantage to slowing things down a bit. But the drilling activity, getting the wells in place and prepared for the future? Of course you want to be there.”

Asked whether Compton might be up for sale, CEO Ernie Sapieha said during a conference call Wednesday the company was not considering it. “It’s just speculation,” he said. “We’re concentrating on our resource plays.”

CFO Norm Knecht added, “We expect there could be some M&A activity, but we wouldn’t be involved.”

“We now plan to drill 360 to 380 wells during 2006,” Sapieha said. “In addition to the specific considerations outlined…we have recognized the impact of current lower commodity prices on overall well economics. This is particularly relevant to tight gas wells, which experience high initial production rates.”

Sapieha said if it delays placing its gas wells onstream until prices move up, returns will improve. “A C$5.00/Mcf difference in realized gas prices can impact the return on a typical shallow gas well with a cost of C$550,000 by as much as C$120,000 during the first six months of production. The natural gas forward price curve would indicate a return to higher prices by year-end.”

The current “operating cost structure” in the WCSB led to the revised spending plans, said the CEO. “The industry continues to operate at maximum capacity with the inherent inefficiencies and cost pressures. The normally expected reduction in service costs subsequent to the winter drilling season and break-up has not, as yet, materialized. We expect this situation to improve. Recently, in reaction to lower gas prices and volatile capital market conditions, companies have begun to reduce their capital programs. These factors should begin to reduce industry activity and cost pressures.”

Compton also has been affected by an “industrywide shortage of qualified personnel, regulatory issues and uncertainties” related to what it said was the direction of global economic challenges.

“We expect the second half of 2006 will see the resolution of a number of factors that are currently affecting the North American energy industry. There should be some clarification as to the direction of global economies, interest rates and the demand side of the natural gas equation in North America. Certainly the impact of the summer heating and hurricane season on the current high natural gas storage levels will be known. In Western Canada, we believe a number of the shortages in services will be resolved and proposed regulatory initiatives will be finalized.”

The producer remains bullish on the longer-term outlook for natural gas and the value of its gas resource plays.

“Certainly, the recently announced Anadarko/Kerr-McGee/Western Gas transaction, among others, would appear to confirm this outlook,” said Sapieha. “Our goal remains that of building a premier natural gas-focused company that will provide superior returns to our shareholders. Our operational plans for the remainder of 2006 are consistent with that goal.”

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