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Compton's Chill Should Pass

Christopher Edmonds

With energy investors already on pins and needles, Compton Petroleum(CMZ Quote) frayed even more nerves this week.

Compton, a small exploration and production company with operations in the U.S. and Canadian Rockies, indicated on Wednesday that they would reduce their capital spending budget by $110 million. The company cited a combination of increased oilfield service costs, a decrease in productivity and a decline in natural gas prices.

Some investors -- especially those bearish on the natural gas markets -- suggested Compton's news could be the beginning of a trend toward reduced activity by exploration and production companies and, as a result, a decline in demand for drilling rigs and other oil field services.

While there is little doubt that the 40%-plus decline in natural gas prices in recent months could impact drilling activity, it is important to put Compton's announcement in context. It is also important to revisit the reasons behind the decline in natural gas prices.

Big Is Beautiful

While Compton did suggest that natural gas prices had something to do with the decision to reduce its capital-spending budget, it is likely gas prices were not the major reason the company chose to take an axe to spending.

Rather, it appears the more prescient reason was likely rising service costs and a decline in service productivity. Those reasons better explain what is going on at Compton.

Smaller exploration companies, like Compton, have found it increasingly difficult to access drilling rigs and other oil field services as demand has grown. In large part, that's due to drilling contractors and other service companies working to "high grade" their client lists. In short, if a drilling contractor has a choice of putting a rig to work for a small company on a one-well contract at a lower price or a multi-well contract at a higher price with a major production company, the smaller company will always get the short draw. Moreover, a service company -- be it a well-stimulation company, compression company or other service provider -- is always going to provide its best crews and equipment to its best customers.

As a result, a decline in service productivity is likely a euphemism for lower-quality service crews and equipment. Unfortunately, that trend will likely continue until the service cycle meaningfully slows. Ironically, Compton's announcement may suggest that the service market is even tighter than expected, with certain services so scarce that cost is rising at the same time that overall quality is declining.

At least one drilling contractor acknowledged that is exactly what is happening to smaller exploration companies. Inexperienced crews, with "just out of mothballs" equipment is being put to the test for smaller clients that have demanded rigs. For companies with complex drilling and service needs, that equation will almost always yield poor results.

In addition to the access to equipment, smaller companies are less likely to have protected their cash flows by hedging production through the potentially weaker summer months. As a result, there will be cases of smaller E&P companies not having the cash flow and balance sheets to meet their original capital-spending budgets. The difference for larger companies is either their hedging acumen -- the ability to sell production forward at more attractive prices -- or stronger (and larger) balance sheets to drill through short-term price corrections. As a result, a Devon(DVN Quote), EOG Resources(EOG Quote) or Anadarko(APC Quote) shouldn't face the same decisions confronting a company the size of Compton.

In either case, it is very unlikely that the Compton announcement -- although an important reminder of the potentially volatile nature of capital budgets -- is the beginning of a wholesale reduction in capital-spending budgets of exploration companies.

Short-Term Price Pressure

It is important to remember that the recent pressure on natural gas prices is almost entirely the result of weather -- the winter of 2005-06 provided near-record warmth. Had winter been normal, it is likely we would be talking about gas prices in the $12-$15 per mmbtu range and wondering if we would be able to build storage to levels necessary to assure a constant supply of gas for the coming winter.

The longer-term natural gas picture has not changed. Production decline rates are still near 30%, net production remains flat even as the number of rigs drilling for natural gas has nearly doubled, and a significant amount of new natural gas comes from unconventional production, some with even higher decline rates.

That means natural gas prices should rebound once the fear of too much gas in storage wears off after summer. And that is exactly what futures prices suggest. The 12-month strip for natural gas is still well above $8 per mmbtu, and 2007 gas is trading around $9 per mmbtu. Moreover, natural gas futures in January, February and March are still trading above $10 per mmbtu, plenty of incentive to keep drilling.

Don't expect many exploration companies to slow their quest for natural gas just because current prices have dropped to near $6 per mmbtu. Remember, the well being drilled today isn't likely to produce natural gas until late this year or into 2007. So, the price of gas tomorrow is a much better predictor of oil field activity than the price of gas yesterday or today.

That should be a comforting message for nervous energy investors.

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