Reaping the benefits of its C$2.3 billion purchase of Rio Alto Exploration Ltd. in May, Canadian Natural Resources, Canada’s second largest producer, reported a 54% increase in natural gas production to 1.43 Bcf/d and a 44% increase in earnings in the third quarter to C$117 million or C86 cents/share.

Earnings were on the low end of analysts’ expectations, which ranged from C$0.69 to C$1.30 with an average of C97 cents, according to Thomson Financial/First Call. The company’s shares fell nearly all week, ending the week at $25.70, which was down from $27.65 a week earlier on the New York Stock Exchange.

Nevertheless, Canadian Natural Chairman Allan Markin touted the “upside potential” of the company’s holdings and its much stronger natural gas side following the Rio Alto acquisition. About 50% of its production is now natural gas. “We will take a methodical approach to developing the northwest Alberta properties and have already identified opportunities for economically unlocking the Cardium natural gas potential,” said Markin. “Over the next few years this acquisition will add significantly to the portfolio of natural gas exploration and development opportunities available to the company.”

Despite the company’s strong production growth from the merger, perhaps its most important play in Canada, Ladyfern in northeastern British Columbia, began to show the steep production declines that had been expected. Ladyfern production fell 11% during the quarter to 178 MMcf/d and is expected to continuing falling sharply in the quarters ahead. “We always expected 70% production declines, but were unsure of when they would commence,” said Markin.

“We knew that this decline would have to be replaced and so, given weaker natural gas pricing, determined it prudent to defer other natural gas drilling to 2003. Consequently, our natural gas drilling is only one-third of what it was last year. In 2003, our natural gas drilling activity will exceed 2001 levels to stem further expected declines from Ladyfern and keep 2003 natural gas production constant from entry to exit.”

Markin said the company’s 2003 budget has two recurring themes: base production will continue to grow at 10%/year and an increasing amount of capital will be spent on projects that do not add production or cash flow until future years. “The 2003 budget provides manageable, efficient 10% production growth and a strong base for sustainable growth in the future,” he said.

Production from properties owned by Rio Alto at the time of the acquisition totaled 410 MMcf/d, and after the effect of normal depletion ended the quarter at 384 MMcf/d. Ladyfern production declined from an average of 201 MMcf/d in the second quarter to 178 MMcf/d during the third. The company currently expects production from Ladyfern to fall 70% through 2003.

The steep Ladyfern decline started in late August as pressures declined and the most down-dip well in the pool watered out. Water encroachment continues into a second well. The company purposefully reduced 2002 natural gas drilling activity to build drilling prospect inventory to offset these anticipated declines. Access to many parts of the Western Canadian natural gas basins is possible in winter months only, precluding an acceleration of replacement drilling.

Canadian Natural plans to continue its exploration program in deeper formations in northeast British Columbia, including the Slave Point trend, where two and possibly three wells will be drilled during the winter of 2003. The Slave Point horizon is technically complex, making it a high-risk exploration target. Canadian Natural’s exploration activities benefit from owning the area’s largest database of 2-D and 3-D seismic information and from its extensive landholdings in the region.

The acquisition of Rio Alto effective July 1, 2002 provides Canadian Natural with a high quality natural gas producing base as well as a new core area in northwestern Alberta with extensive opportunities on a large undeveloped land base. The undeveloped land contains multiple zones for natural gas production supported by a large amount of seismic data and pipeline and natural gas plant infrastructure. Canadian Natural will commence development of this land in the first quarter of 2003 with the drilling of up to 52 wells.

During 2002 Canadian Natural drastically reduced the number of natural gas wells drilled from the 476 net wells in 2001. The company’s natural gas drilling program will be expanded in 2003 with the planned drilling of 580 wells on lands with natural gas potential. About 240 of the wells will be drilled in the first quarter on lands with winter-only access. The remainder of the well program, including 250 southern Alberta shallow wells, are scheduled for lands with year-round access.

Canadian Natural is currently budgeting a cash flow from operations in 2003 of $2.4-2.5 billion from expected production of 1,280-1,330 MMcf/d of natural gas and 240,000-260,000 b/d of oil and liquids, and current strip pricing averaging West Texas Intermediate crude price of US$24, a WTI to LLB oil differential price of US$8.50 and an AECO natural gas price of C$5.20/Mcf.

Natural gas prices in the third quarter decreased from the previous quarter partly because of restrictions on export capacity out of Alberta due to temporary anomalies resulting from maintenance downtime on common carrier pipeline systems. AECO prices decreased 27% to average C$3.25/MMBtu compared to $4.43/MMBtu in the second quarter. AECO prices averaged C$3.68/MMBtu for the first nine months of 2002 compared to $7.27 in 2001.

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