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Lower Gas Prices, High Service Costs Dampen E&P Profits

With the third quarter earnings season under way, record oil prices have not yet translated into record profits for some of the largest U.S.-based exploration and production (E&P) companies. Smaller domestic producers are performing well, but lower natural gas prices and sharply higher service costs are cutting into the profits of larger and more diversified U.S.-based E&Ps.

On Wednesday, the third-largest U.S.-based major, ConocoPhillips, was the first of the majors to report quarterly earnings, announcing slightly higher 3Q2006 profits and production, but most of it came from a merger with Burlington Resources and its investments in Russian-based Lukoil. Canada's largest gas producer, EnCana Corp., reported strong earnings and gas output, but it put the brakes on its North American growth in the short term, citing volatile market conditions and high service costs.

Among the smaller U.S.-based independents, CNX Gas Corp. reported better-than-expected earnings and record production. Pogo Producing Co., which is planning to sell some of its domestic on- and offshore properties by early next year, reported a 23% jump in gas production, but its quarterly net income fell sharply.

Houston-based ConocoPhillips' upstream results were negatively impacted by planned downtime in some of its exploration areas, as well as the unexpected partial shutdown of the BP-operated Prudhoe Bay field in Alaska.

Worldwide, Conoco's acquisition of Burlington Resources boosted quarterly production to 2.47 million boe/d from 1.52 million boe/d in 3Q2005, but the output was sequentially below 2Q2006's 2.13 million boe/d. In the United States, Conoco's gas production jumped to 2.44 Bcf/d from the 1.39 Bcf/d reported in 3Q2005. Average U.S. gas prices in the quarter were $5.98/Mcf, well below the $7.48 in 3Q2005.

Conoco's quarterly net income reached $3.88 billion ($2.31/share), slightly ahead of the $3.8 billion ($2.68) in 3Q2005. However, Conoco's quarterly profit dropped significantly from the windfall posted in 2Q2006, when earnings rose 65% from 2Q2005 on higher commodity prices and the Burlington Resources merger (see Daily GPI, July 27). Net income in 3Q2006 was negatively impacted 37 cents/share from new tax legislation in both Alaska and the UK, impairment of some refining assets held for sale, and higher insurance costs.

"Looking ahead to the fourth quarter, we expect our upstream production to increase, reflecting the resumption of operations at Prudhoe Bay, normal seasonality and less scheduled downtime in the United Kingdom and Venezuela, partially offset by production sharing contract impacts in the Timor Sea," said CEO Jim Mulva.

Softer gas prices and record storage levels led EnCana to reduce its North American E&P activity. There was no talk about shutting in wells, but the Calgary-based independent released its least capital-efficient rigs and associated services in North America, a move expected to delay the ramp-up of new production. Most of the lost production is from the Jonah field in Wyoming, where production growth is off about 50 MMcf/d more than EnCana originally forecast, and in southern Alberta, where heavy rains hampered field work.

"Although we have slowed our natural gas production growth profile from our original plan, we have achieved year-to-date growth of 5%," said CEO Randy Eresman. "Our current production is about 3.4 Bcf/d, and with the planned start-up in early November of the new Steeprock gas plant in British Columbia, our gas production should approach 3.5 Bcf/d."

EnCana's net income in the quarter jumped to $1.36 billion ($1.65/share) from $266 million (30 cents) a year earlier. Sales after royalty payments climbed 31% to $3.92 billion. EnCana's quarterly realized gas prices, including hedging, averaged $6.57/Mcf, down 5% from $6.90. Excluding hedging, gas prices averaged $5.75/Mcf, down 21% from an average $7.29 in 3Q2005. About 1.2 Bcf/d of expected 2007 gas sales were hedged as of Sept. 30.

In total, EnCana has about 70 rigs running, which is 55 fewer than in 3Q2005. It expects to drill about 3,650 wells this year, 650 fewer than originally forecast. The updated 2006 gas production guidance is a range of 3.36-3.40 Bcf/d, which at the midpoint is 5% higher than in 2005. In 3Q2006, EnCana sold some of its assets to focus on gas fields in North America and on oilsands projects in northern Alberta. Earlier this month, EnCana and ConocoPhillips agreed to jointly spend $10.7 billion to build an oilsands business.

With less overhead and a laser focus on finding gas in the Appalachian Basin, Pittsburgh-based CNX reported solid quarterly earnings, and its gas production hit a company record. CNX reported net income of $37.6 million (25 cents/share), up 44% from 3Q2005's $26.1 million. Gas production rose 15% to 14.4 Bcf, or 156.8 MMcf/d, from 12.5 Bcf, or 135.7 MMcf/d, a year earlier.

"Our results show that in an environment where gas prices are a concern to the investment community, CNX Gas can grow production while accumulating cash and generating a very healthy return on capital," said CEO Nicholas J. DeIuliis. "For the year-to-date, we've shown over 15% organic production growth, accumulated $87.5 million in cash, and generated an annualized after-tax return on capital in excess of 21%."

The average price realized for CNX's gas production, including the effects of hedging, was $6.62/Mcf, 11% higher than the $5.95 received a year earlier. Fully loaded unit costs for company production, exclusive of royalties, were $2.85/Mcf, about 5% higher than the $2.71 reported in 3Q2005. Pre-tax unit margins for company production were $3.77, up 16% from $3.24 a year earlier.

CNX's 2006 production guidance remains unchanged at 55.7 Bcf, representing a 15% increase over 2005. By the end of 2006, CNX plans to drill 250 wells in its Virginia operations and 18 in its Mountaineer operations.

Houston-based Pogo on Tuesday reported that net income fell to $33.3 million (58 cents/share) from $473.5 million ($7.89) a year earlier, when results were boosted by a property sale gain. Revenue jumped 28% to $353.7 million from $275.8 million.

Gas production climbed in the quarter, averaging 273.7 MMcf/d, compared with 222.5 MMcf/d a year ago. However, Pogo said production continued to be impacted by the shut-in of more than one-third of its Outer Continental Shelf volumes because of Hurricanes Katrina and Rita. About 8 MMcf/d of Pogo's net offshore gas production capacity and 3,100 bbl/d of crude oil production are still being postponed. Those curtailments are expected to continue until completion of repairs to gathering and terminaling facilities, as well as joint venture-owned platform facilities, Pogo said. Gas prices fell to an average of $5.81/Mcf in 3Q2006 from $7.95 in 3Q2005.

Pogo raised the 2006 capital budget 10% to $880 million. The additional money will be spent on its Austin Chalk play in East Texas, the Granite Wash play in the Texas Panhandle, and the Bakken shale play in North Dakota, where Pogo has accumulated additional leasehold acreage and will be drilling the first two exploratory wells in December.

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