In first-quarter 2005, many of the larger upstream Canadian producers had strong production, while the smaller companies didn't fare as well. What they had-and continue to have-in common is a strong penchant for hedging and continued expansion efforts in spite of some bruised credit ratings. Many of the senior Canadian producers have recently undertaken major development projects, which pose some threat to their credit profile, says Michelle Dathorne, Standard & Poor's credit analyst. "Many of the negative rating actions taken in the recent past were the result of M&A activity. The upstream companies most affected by these negative ratings revisions have begun accelerating capital spending for their expansion projects. As a result, they generated negative free cash flows in the first quarter, despite continued strong hydrocarbon prices." As companies like Canadian Natural Resources Ltd. and Nexen Inc. move forward with their Canadian oil-sands and international development projects, there could be additional strain on their financial profiles if capital spending exceeds their current forecasts, she adds. To offset these risks, many Canadian producers engaged in large-scale capital programs are looking to commodity-price hedges to limit the downside cash-flow exposure. "Although many of these companies, notably Canadian Natural Resources and EnCana Corp., reported significant unrealized risk-management losses as a result of their risk-management initiatives, these charges do not affect operating cash flows. "Furthermore, S&P views their hedging strategies as supportive of credit quality. Given the material capital spending these companies will incur in the near to medium term, the commodity-price hedges serve to temper hydrocarbon price volatility and provide some measure of cash flow certainty." S&P expects that commodity prices will stay strong for the remainder of 2005, averaging US$40 per barrel or higher for West Texas Intermediate and Henry Hub gas prices of US$5 per million Btu or more. These price decks reflect sharp increases from S&P's assumptions earlier this year. "Why the large near-term jump in oil-price assumptions? The short answer is fundamentals; the oil and gas industry is operating with a low margin of excess capacity that will require time to rebuild. "Although the oil industry operated for much of the past 20 years with a high degree of excess capacity, that spare capacity has largely been depleted as a result of demand growth and the time needed for the industry to expand production." S&P expects producers will struggle through 2006 to add new production. "Still, there is little doubt that there has been a fundamental shift in cost structures within the industry and that even the largest companies have raised considerably the commodity-price threshold for investment decisions and long-term investment. Furthermore, most companies have struggled mightily to replace production organically, lending credence to the theory that quality prospects are in shorter supply than just a few years ago." For the long haul, Dathorne expects only modest incremental supplies to U.S. markets from conventional and new sources until 2007, when more liquefied natural gas terminals and tankers become operational.