The significant rise in natural gas and oil prices since the first of the year has so far done nothing to encourage exploration and production (E&P) companies to increase their 2002 drilling budgets, said Salomon Smith Barney energy analyst Robert Morris Tuesday. Noting the clear trends emerging from first quarter reports, most producers appear willing to wait for compelling evidence that prices will remain on the rise, and use the cash flow from the current higher commodity prices to reduce debt and pursue acquisitions.

SSB analyst Robert Morris found “noteworthy trends” emerging from the 24-company coverage group, which includes most of the large-cap names. “Interestingly, while initial 2002 exploration and development budgets were based on WTI spot crude oil and composite spot natural gas prices of roughly $22/bbl and $3/MMBtu, on average, the current 2002 Nymex equivalent future contract (incorporating actual prices year-to-date) reflects roughly $25.10/bbl and $3.20/MMBtu. Thus, based on current Nymex futures expectations, full-year 2002 exploration and development budgets for our coverage group, on average, would equate to roughly 80% of after-tax operating cash flow. Even based on our current forecast of $22.75/bbl and $2.85/MMBtu for the full year, budgets equate to only 86% of our cash flow projections.”

Instead, said the analyst, most E&Ps are indicating they are “more likely to apply any incremental excess cash flow from higher-than-anticipated commodity prices near-term to reduce debt and/or to pursue acquisition opportunities to augment their future drilling inventory.”

Most of the companies have already stated that “any hesitation to accelerate drilling endeavors should not be interpreted as a lack of ‘drill-ready’ projects or a shortage of geoscience personnel,” he wrote. “Instead, companies want to gain more confidence in the sustainability of the recent run-up in commodity prices and/or are focused on ‘capital discipline.'” Also, many will improve their balance sheets to prepare for potential acquisitions later this year.

Recent and expected asset rationalization programs by larger E&Ps, including Burlington Resources, Devon Corp. and EnCana, as well as integrated energy merchants such as El Paso Corp., “are expected to yield an abundance of acquisition opportunities,” Morris said. ” In fact, XTO Energy Corp. and Houston Exploration Co. recently reduced their 2002 exploration and development budgets to partially offset capital outlays associated with property acquisitions.”

More emphasis on acquisition opportunities and “capital discipline,” he said, is consistent with the fact that “the acquisition of reserves has come with a much lower price tag than the drill bit in recent years.” The aggregate cost for SSB’s coverage group to acquire proven reserves in 2001 was just below $7/boe, about 20% lower than the $8.82/boe average cost for exploration and development, excluding revisions.

“Meanwhile, regarding skepticism as to whether the recent rise in crude oil and natural gas prices is sustainable, several companies have taken advantage of the recent strength to lock in attractive crude oil and natural prices for a significant portion of their second and third quarter projected production,” said Morris. “In fact, companies in our E&P coverage group, on average, have hedged nearly 50% of their estimated second and third quarter North American natural gas volumes and nearly 28% of their estimated crude oil production.”

However, the same companies, on average, have only hedged 32% of their estimated ’02 fourth quarter production and only 7% of their estimated full-year ’03 North American natural gas production. “At the same time, they have hedged roughly 24% of their estimated fourth quarter ’02 and less than 4% of estimated full-year ’03 crude oil volumes.”

Morris found no sharp deviations in expected first quarter North American gas production for the independents, but found that “several have come up slightly short of projections, unlike the sharp shortfall reported by several of the major integrated companies.” First quarter domestic natural gas production for SSB’s coverage group (including estimates for those companies that have yet to report) declined nearly 2.5% sequentially, in line with other analysts’ estimates.

However, Morris noted that “early estimates for these same companies indicate that production will be up slightly (0.6%) in the second quarter,” generally associated with specific projects such as the deepwater Gulf of Mexico Nansen field ramp-up for Kerr-McGee Corp. and Ocean Energy, and several conventional and ‘deep’ shelf projects that Newfield Exploration and Spinnaker Exploration plan to bring on line.

For companies with significant Canadian operations, including Anadarko Petroleum Corp., Apache Corp., Burlington Resources, Canadian Natural Resources, EnCana, Nexen, Unocal and Talisman, Morris said they “tend to allocate a disproportionate amount of their full-year budget to the first quarter for winter-access only drilling programs. As a result, second and third quarter Canadian volumes for these companies should benefit from the timing of these winter drilling programs.”

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