Recent spending patterns by North American natural gas producers indicate support for a New York Mercantile Exchange price of around $7.50/Mcf to sustain development, especially in some of the more costly shale plays, according to an energy analyst with John S. Herold.

A $7.50 gas price is "supported by the fundamentals driving the sector," said Herold senior equity analyst Daniel T. Pratt. "Good returns are to be had at that price level." Pratt noted that "North America is still among the most profitable regions of the world...Capital continues to flow" into the region, which has resulted in "record upstream spending."

According to Herold research, U.S. exploration and production (E&P) spending jumped 76% from 2005 to 2006; Canada also had double-digit growth. Today however, "E&P margins are under pressure because of a run-up in costs," he said. And the decision by Alberta to raise its oil and natural gas royalty regime "will affect Canadian production when it kicks in 2009." The higher costs and possibly higher taxes "will start to narrow natural gas activity."

Gas prices took a "long slide" following the tumultuous hurricane season in 2005. Now higher finding and development costs "are flowing through to the income statements." Between 2000 and 2006, "total operating costs doubled," but with higher oil and gas prices over that period producers were able to keep up and bank their cash even as service costs escalated.

Herold's preliminary research indicates that in the first six months of 2007, service costs rose about 18% from a year ago, at a time when gas prices were "just under $8/Mcf and rigs were up to 1,500, which pushed production up," Pratt said. In the third quarter, it appears costs "trended down slightly from the second quarter, about 5%." Herold expects some additional recovery in the final quarter.

With pre-tax operating costs "well in the $5/Mcf price range...when prices fall below $7, producers are forced to shut-in operations because of the economics. Whether we are drilling up another surplus, we don't see prices falling too far below $7 for a period of time because then the decline rates would kick in," he said.

"Returns vary across the board, but one thing is clear, to earn a return on investment, producers need $6.50 to $7 gas prices" and to sustain development, costs need to be a little higher, said Pratt. Companies "that are long on resources, particularly within plays that generate higher margins and better returns, will be best suited to increase shareholder value going forward."

On Friday Moody's Investors Service said in a report that "surging costs are limiting the positive impact on historically high oil and gas prices" for independents, which may pose a risk to the sector's stable rating outlook. In all, Moody's rated 60 independent E&Ps.

"High oil and natural gas prices have produced robust revenue for the independent E&Ps during the last few years," said Moody's Steven Wood, lead author of a new industry outlook on the E&Ps. "But even as these commodity prices have reached historic highs, an accompanying surge in costs has damped the financial benefits of the windfall."

Moody's said operating and capital costs rose 20% or more per year in both 2005 and 2006, and they have continued to increase during 2007, albeit at a slower rate.

"Costs are unlikely to decline in the near term, said the credit ratings agency, and they will continue to pressure margins, reduce free cash flow and increase leverage for the E&Ps. For 2007, Moody's expects margins to be flat to lower across the industry.

The high-yield E&P companies are more vulnerable to the rising costs than are their investment-grade counterparts, given their relative lack of scale and diversification, Moody's noted. Full production cycle costs for a barrel of oil equivalent were $36.07 during the first six months of 2007, compared with $30.90 for investment-grade companies.

"Operating cash flow performance among the two groups echoes this split," said Moody's. "In each year since 2003 and in the first half of 2007, free cash flow has been positive for the investment-grade companies but negative as a whole for their noninvestment grade peers. In the first half of 2007, the E&P companies collectively outspent their operating cash flow following four years of overall positive free cash flow."

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