A continued decline in natural gas prices could pose one of the biggest threats to the credit quality of producers in the fourth quarter, according to a new Standard & Poor's (S&P) report released last week.

"Prices continue to be volatile -- for example, they rose to around $7 Mcf in late August on fears that Hurricane Dean would interrupt Gulf of Mexico production, and promptly fell to nearly $5 Mcfe when those fears proved to be overblown. If relatively mild weather and an uneventful hurricane season persist, then natural gas storage levels could rise and further pressure prices," said S&P credit analyst Andrew Wyatt.

"This would dampen favorable operating conditions for natural gas producers and oilfield service providers and ultimately hinder any further improvement in credit quality," he noted. "If prices in general stay in the area of $5 Mcf over the next several months, we would expect that investment-grade [exploration and production] companies would still generate satisfactory returns, and that many 'B' and some 'BB' rated natural gas producers could struggle to replicate the solid operating and financial performance of the past few years. However, the fact that many speculative-grade natural gas producers have hedged a significant portion of their production at relatively favorable commodity prices offsets some of these near-term concerns."

Meanwhile, "impediments to credit quality are growing as we approach the last quarter of 2007," Wyatt said. "Turmoil in the credit markets and rising investor concerns about liquidity and underlying credit quality will limit access to capital markets for some issuers. We surveyed the rated companies in the sector and have found that most have adequate liquidity to satisfy foreseeable liquidity needs associated with upcoming debt maturities and defined capital spending requirements."

A number of independents are pursuing large capital budgets -- at or in excess of internally generated cash flow -- in an attempt to increase production organically, Wyatt said. Companies, such as Plains Exploration & Production, Pioneer Natural Resources and Petrohawk Energy Corp., also are considering the "formation of master limited partnerships (MLP) to which they would drop down low-growth, long-lived assets in the hope of receiving a higher market multiple on them."

However, "we would view the formations of the MLPs as detrimental to credit quality given their untested record and the significant commitment of unitholder distributions," he said.

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