This column was originally published on RealMoney on Oct. 6 at 12:33 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.SAN FRANCISCO -- Like autumn leaves, interest in oil and natural gas is falling, if the anemic attendance at this week's Independent Petroleum Association of America (IPAA) investor confab is any indication. But the sector's fall from grace, confirmed by the recent sprint away from energy equities, could actually signal the beginning of a new base of support for the stocks. Natural gas storage and shoulder-month crude demand may continue to pressure commodity prices, but Tuesday's apparent capitulation in energy equities provides early evidence that the swift correction is near its climax. Although volatility will probably remain the norm as energy equities work to find new support, we could be witnessing the start of that basing process.
The rig market is moderating. My conversations with a number of exploration-and-production companies revealed that rig availability is no longer a serious issue and that rig rates are moderating, some as much as 30% off recent highs. One operator indicated that it took a pass on six rig offers in the past 10 days, most at least 20% off their highs with no term contract requirements. The impact will first be felt by companies with fleets of lower-power rigs, as exploration companies work to improve the quality of rigs under contract, possibly securing a more powerful rig at prices similar to those paid for smaller rigs. If true, companies such as Patterson-UTI ( PTEN - Get Report) and Union Drilling ( UDRL) will probably feel the pinch before those with higher-horsepower fleets, such as Helmerich & Payne ( HP - Get Report) and Nabors ( NBR - Get Report). Exploration and completion activity is adjusting to lower prices. Announcements about shut-ins from Chesapeake ( CHK - Get Report) and Questar ( STR) were front and center in discussions with oil and gas companies at the IPAA this week. While most exploration companies remain in the "we will drill through it" camp, some are acknowledging that they're slowing or considering slowing production to avoid depressed gas prices. For example, PetroQuest ( PQ) -- while not shutting in production -- indicated that it's looking at choking back certain production to avoid low-cost gas sales. Parallel Petroleum ( PLLL) hints that completion and connection work is not as rushed, and the company is "not eager to push gas" into a sub-$5 market. I continue to hear suggestions that a number of wells in resource plays -- such as the Barnett Shale -- have been drilled, but completion and connections are delayed in hopes of higher gas prices. I expect to hear similar anecdotes ahead of and during third-quarter earnings releases. As a result, I believe the bias will be toward downward revisions in overall production guidance for the fourth quarter and into early 2007.
Capital discipline from many E&P companies remains evasive. While comments from the likes of Parallel are encouraging, a number of smaller exploration companies remain in denial about the potential impact of lower natural gas prices on cash flow and capital budgets. They're content to use leverage to drill through the trough in gas prices. If the price decline is short-lived, there may be few problems, but declining cash flows combined with higher costs of capital could lead to financial pain. I'm especially cautious about companies that propose large prospective capital-budget increases based on aggressive natural gas price assumptions without commensurate growth in cash flows. For example, the aggressive $110 million to $130 million 2007 capital budget from GMX Resources ( GMXR), which will be funded with nearly $100 million in debt, is somewhat surprising, especially if natural gas prices don't rebound from here. Capital-budget discussions have been key among exploration companies at the IPAA, and I expect scrutiny of those budgets to increase. Making a bet on uncertain future events can be a risky proposition, especially when considering leverage. Given steep decline rates, challenging natural gas production and the continued rise in costs associated with producing from new natural gas and oil prospects, the long-term outlook for high-quality energy companies remains robust. But, as is often said, markets seldom move in a straight line, and this is exemplified by the recent correction in commodity prices and energy equities. While energy should remain a part of most equity portfolios, it's more important than ever to be selective and understand the volatility that could lie ahead.