To practiced observers, a number of trends this past summer point the way to enhanced natural gas prices in the next 12 to 18 months, if not as soon as this winter. Ask any major buyer of a gas-rich independent company what it sees on the horizon and this is part of the rationale for the deal. The extreme events of last winter on the upside and this summer on the downside are indeed hard to take, especially as companies enter the fall budgeting and planning season. However, we believe these wild swings have already sown the seeds of the next up-cycle. Second-quarter gas production for a wide swath of the majors and independents in the U.S. and Canada was up a negligible amount, if one discounts the effect of acquisitions and reserve revisions. This is happening despite greatly increased drilling activity that in fact reached a 15-year high earlier this year. The worrisome decline curve has not flattened. In August, the rig count started to slide, although the year-to-date average was still about 1,550 in North America, a 34% increase from the prior year. But analysts are starting to call for a 10% to 20% decline in North American drilling activity for the rest of this year, at a time when traditionally the fourth quarter is the busiest. This is unfortunate in light of the supply-demand fundamentals, although not surprising given that so much seems to be driven by industrial demand uncertainty, the economic slowdown and full gas storage. Who in his or her right mind would have bemoaned fate when natural gas prices were "as low as" $3 per Mcf? "Everyone became myopic this summer," says Bob Simpson, chairman of XTO Energy. "They are focusing on storage numbers which represent only 1% or 2% of U.S. production. Everybody knows full storage tends to soften the price but we all need to look much longer term." In the past year, Canadian operators drilled 8,900 gas wells, yet without the new production that just came on from the hugely impressive Ladyfern finds in northeastern British Columbia, production would have been essentially flat, according to Roger Biemans, president of AEC Oil & Gas (USA) Inc., the Denver-based arm of Calgary's Alberta Energy. AEC is producing 130 million cubic feet a day out of just four wells there (it owns 100%), and other operators are reporting similarly good results. "A lot of independents are laying down rigs in western Canada. This is not a sea change, but more a gut check" to see that spending remains in line with commodity prices and the quality of prospects, Biemans said. He spoke at The Oil and Gas Conference, which was jointly sponsored by Oil and Gas Investor, EnerCom Inc., Netherland Sewell and the American Stock Exchange. Some 60 companies presented their stories to more than 600 registrants at the Denver meeting. In the U.S. in recent weeks, the rig count has flattened-and actually dropped some in the Gulf of Mexico. But there is trouble ahead. The Rockies gas price differential to that of Henry Hub has widened during the past 12 months due to increased gas production in the region, squeezing the pipeline take-away capacity. A number of pipeline expansions have been announced that should minimize this problem, over time. The frustration of CEOs of vastly undervalued companies is palpable. Most of the service and supply companies reported outstanding results in this year's first half, yet their stocks are near 52-week lows or worse-most are still down 40% to 70% from their 1997 peak, according to data from A.G. Edwards' service sector analyst Poe Fratt. The momentum investors are looking no further than falling gas prices and rising gas and crude oil inventory. E&P analyst Mark Meyer of Simmons & Co. International says energy stocks have hit an air pocket, but do not face a meltdown. He, like most other analysts, has lowered his oil and gas price projections for the year and therefore, earnings estimates as well. But he is thinking about the future. "We believe the long-term risk-reward remains compelling as the cycle remains intact. Significant near-term uncertainty is merely an energy investing 'fact of life.' This air pocket does not change the fact that the E&P industry is severely prospect-limited." The frenetic pace of drilling that characterized the last 12 to 18 months could mean many operators face depleted prospect inventories, he adds. "Our surveillance suggests that many companies were drilling physically marginal targets justified solely by $4 to $5 gas prices. Now, a multiquarter reduction in drilling will result in further supply-side tightness." Simpson said, while at the Denver meeting, "This industry is throwing all the rigs and people we can at the problem and we are not seeing the supply response. If a commodity tends to get scarce, that tells me this is a great business to stay in. But it is hard to communicate to outsiders how tough it is to grow reserves."