The prospect for better-than-average natural gas prices in 2003 remains good because of lower production levels and the “continued anemic drilling activity,” according to a new “Oil & Gas Report Card” by Standard & Poor’s Ratings Service (S&P). The positive fundamentals, said analysts, are reflected in a 2003 futures strip of about $4/MMBtu.

In its focus on North American natural gas, S&P analysts remain “cautious on the near-term direction…of gas prices, as inventories still remain elevated versus the five-year average (11%), and last year (5%), and the industry is approaching a period of seasonally weak demand.” Even though natural gas prices have risen to nearly $4/MMBtu in recent weeks because of “lower inventory building, higher oil prices and hurricane fears,” producers likely will increase the pace of inventory injections “as weather-related effects diminish.”

Canadian and Rocky Mountain-focused producers “have been stung” this year by “unexpectedly wide basis to the Henry Hub spot price,” said analysts. The natural gas spot differential between delivery points in the Rocky Mountains and Canada and the U.S. Henry Hub, “which has averaged US85 cents/MMBtu in the first eight months of 2002 and exceeded US$2/MMBtu between September 2001 and August 2002, largely reflect short-term storage and weather factors, which are not expected to remain in effect in the medium- and long-term.” Even with the near-term weakness in prices and the widening basis differential, “Canadian natural gas production remains competitive, even at these lower price levels.”

Before the “trapped-in-Alberta” discount caused by insufficient pipeline capacity out of the Western Canadian Sedimentary Basin, analysts said, “Canadian producers were able to generate positive netbacks at realized prices below C$2/Mcf. New pipeline capacity has eliminated the discount, and in the absence of prolonged weather and over-supply factors affecting pricing, the Canada-U.S. differential should trend toward US50 cents, thereby reflecting the average transportation costs between the [Canadian basin] and the U.S. Midwest.” Also, said S&P, similar increases in export pipeline capacity “should help Rocky Mountain producers.”

The expectation of growing demand, and the “relatively steeper production decline curves” in the United States “continue to support the strong fundamentals for Canadian and Rocky Mountain natural gas production,” said S&P.

For the exploration and production (E&P) industry, analysts noted that “aside from changes in commodity prices, the principal issues…are depletion (particularly for North American natural gas), cost containment, merger and acquisition activity and sovereign risks.” This year, most of the larger producers are expected to post U.S. natural gas production declines versus 2001, excluding any effect from acquisitions.

While some companies have been reluctant to invest “sufficiently” to maintain production, mostly because of the uncertainly of future commodity prices, others — like Devon Energy and Burlington Resources — are “recovering from large debt-financed transactions, which…contributed to greater capital discipline. If prices remain strong into 2003, capital budgets could rise, leading to increased production and returns on capital and the possible expense of free operating cash flow.”

S&P analysts found that cost containment “is likely to be an ongoing focus for E&P companies.” Analysts noted that in the past several years, finding and development costs have increased materially in response to higher services costs and a secular trend toward developing less prolific prospects. “While high prices have compensated for increased costs, many companies may struggle to deliver adequate returns on investment in low-pricing environments without improved cost containment. Given secular factors of smaller prospects and accelerating depletion, cost containment may be highly dependent on technological innovation, which can be slow to develop.”

Finally, noted analysts, mergers and acquisitions (M&A) are expected to contribute to ratings changes. “The frenetic pace of consolidation seen in 2001 appears to have abated for the moment, but accelerating depletion rates and an easy fund-raising environment for companies of good credit quality easily could re-ignite activity. Companies that incur substantial indebtedness through M&A activity are likely to be candidates for downgrades. Acquisition targets are likely to be upgraded if they are purchased by a higher-rated company.”

To learn more about the report, visit the web site at www.standardandpoors.com.

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