Compton's Chill Should Pass

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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