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'Soggy' 1Q, but Watch for Canadian Supply Shrinkage, Says Analyst

Market conditions have been shaping up to deliver weak natural gas prices in the first quarter, which could represent a buying opportunity for utilities and commercial/industrial users, one equity exploration and production (E&P) analyst told NGI. However, prices could very well strengthen later in the year as Canadian exports to the United States decline and U.S. producers "tap on the brakes" when it comes to spending.

"It's just really not looking good for the first quarter of '07," said Irene Haas, principal with Canaccord Adams Inc. "I think by now we have enough weeks of consumption data behind us that it's just really looking somewhat bearish, especially if the weather report that talks about a warm January, February and March is remotely true, then we're going to wind up this season with quite a bit of excess in storage again."

The near-term could present an opportunity for local distribution companies and commercial users of gas to lock in prices. But the opportunity isn't likely to last, as less gas from Canada is available for U.S. markets; U.S. producers slow their spending, and decline rates -- particularly from unconventional plays -- continue to increase.

Canadian producers have cut back on spending, given high costs for rigs and services and weaker commodity prices. Additionally, noted Haas, the royalty trust sector is responsible for about 20% of Canadian production. The trust sector is poised for consolidation and other adjustments over the next 6-12 months as it deals with a new business environment with the expected loss of its tax advantages (see Daily GPI, Nov. 2).

"I think for years we've been taking it for granted that the Canadians would hold their gas production flat, but this could be an interesting turning point," she said, noting that changes in Canada will soon impact production and exports to the United States.

"On the U.S. side we have not seen, overtly, anybody talking about capex reduction and things of that nature, but I would suspect that they're going to be tapping on the brake just a little," Haas said. "I think in the U.S. you don't need to do a massive rollback [in spending] before you see the impact. The reason I say this is because of the maturation of production."

In 1999 initial production from a typical U.S. gas well was around 800 Mcf/d, but by 2005 it had dropped to about 500 Mcf/d, she said. Further, more new production is coming from unconventional sources, such as tight sands and shales, which have even steeper decline rates.

There is some good news for producers on the cost side, as it would seem that after three years of rising rig and service company costs the industry has reached something of a plateau. "With the [commodity] pricing looking so soggy this spring going forward, I think that would tend to put pressure on the service sector as well," said Haas.

After three years of "really high" commodity prices, producers could be due for a change in weather. A robust Nymex forward curve favors checkbook-driven growth, as that offers acquirers hedging and financing opportunities and investors relatively low-risk returns. Softer prices could herald a swing back to a preference for organic growth where companies with exploration exposure are favored.

"We're entering a different period now so, pretty much we've been trying to pick [companies with] stories that have internal [growth] catalysts and hopefully some pretty big growth driver," said Haas. "Even in the flattened commodity pricing environment they would still show earnings and cash flow growth.

"It's really interesting because I think we're going through an inflection point. If you look at the last three years the stories that tended to do really well would be like XTO [Energy] and Chesapeake [Energy], and those are mainly very low-risk acquisition models. It tends to work really, really well as pricing is escalating. Investors would rather have a lower risk story than a high risk. I think now in a flatter pricing environment the preference could change."

Companies Haas likes for their organic growth potential in 2007 include Noble Energy Inc., Newfield Exploration Co. and Quicksilver Resources Inc. All three are Canaccord Adams clients, she noted.

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