Upstream capital spending is pegged to jump a healthy 20% this year versus 2006. However, with most of the money earmarked for international oil projects, North American exploration and production (E&P) companies weighted to natural gas are not expected to deliver over-the-top earnings through the rest of the year, according to several energy analysts.

E&P earnings reports for 3Q2007 will begin in the coming weeks, but already, several of the biggest domestic producers, including Chevron Corp., ConocoPhillips and BP plc, are preparing investors for a bumpy ride. Canadian producers are not expected to fare any better. Independent Edge Petroleum Corp. on Tuesday said it would defer some U.S. production until gas prices improve (see related story). And Calgary-based oilfield services provider The Mullen Group Income Fund on Friday said it will begin laying off employees because of a downturn in drilling (see related story).

Energy analysts John Gerdes and Michael Dane don't expect to see any good news for gas producers this year unless gas prices increase. The SunTrust Robinson Humphrey/Gerdes Group (STRH) analysts noted that already, the North American E&P sector is about 30% free cash flow negative this year in a $7/Mcf average gas price environment, and "the industry appears unlikely to maintain the current level of drilling activity without a material improvement in gas prices."

If gas prices remain at the $7 level in 2008, it likely would result in a 15% reduction in North American drilling activity, Gerdes said.

"Even under this reduced drilling scenario, the E&P industry would remain 15% free cash flow negative," he said. "Moreover, the meaningful negative supply consequence of 15% lower North American activity should reasonably support an $8-plus gas price environment." An $8.25/Mcf gas price in 2008 "appears necessary to provide the financial incentive to modestly increase North American drilling activity and maintain market equilibrium."

Net marketed U.S. onshore supply data suggests slower 2007 growth versus last year, the STRH analysts noted. The data "oscillates month to month," but "the overall trend in growth in U.S. onshore gas production over the past year does appear to be slowing in accordance with slower growth in gas-directed drilling activity. Assuming a 1,475 average gas rig count this year, the relationship between drilling activity and production suggests an approximate 5% deterioration in well productivity this year, which would be at the low end of the long-term trend of 5-7% per annum deterioration in well productivity."

Standard & Poor's (S&P) said several things will weigh on the gas-focused producers and service providers through the end of the year.

"Credit quality in the oil and gas industry is likely to remain solid over the final quarter of 2007, drawing from the ongoing strength of crude oil prices and the generally stout credit profiles of rated issuers," S&P analyst Paul B. Harvey said. "The healthy cash flows resulting from crude's strength should provide for continued high reinvestment in the exploration and production sector and, in turn, filter down to the already strong backlogs in oilfield services."

However, natural gas prices are lagging crude prices, "reflecting the resource's more regional nature and the recent mild weather patterns across North America," said Harvey. In addition, "jitters" in the credit markets have halted some debt issuance and "clouded the prospects" for merger and acquisition activity. In the upcoming months, the "wild cards" for gas prices "will include seasonal weather patterns entering the winter heating season, Canadian natural gas export levels, the positions of market speculators and changes in liquefied natural gas imports."

Energy analyst Stephen Smith said his best bet is that crude prices will "weaken a bit over the next few months but that this will not be severe nor will it be particularly threatening to E&P shares...The risk is that we have another freakishly warm fourth quarter like last year. This is not the most likely case but it is a nontrivial risk." The "gas-oriented E&Ps may have the potential to be overweighted in the weeks ahead but [we] would prefer to wait until mild fall weather makes the overweight more compelling."

Raymond James & Associates Inc. analysts increased their full-year gas price estimate from $6.70/Mcf to about $7/Mcf "based on our belief that natural gas prices will rally for the first half of winter due to easy weather comps. However, going into 2008, we believe that the U.S. supply growth, as well as the continued influx of liquefied natural gas (LNG) imports, will likely drive higher-than-normal gas inventory builds through the summer of 2008."

Raymond James cut its 2008 gas price to $7/Mcf from $10 in mid-September. Down the road, however, analysts expect to see an upswing. "For 2009 and beyond, we see gas prices gradually trending to a more normal 7:1 ratio with oil prices by 2012."

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