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Canada has a looming energy challenge and it has nothing to do with Kyoto. Canada's supplies of clean-burning natural gas are tight and getting harder to find. There are concerns that conventional gas production has peaked and could be headed for a permanent decline unless significant new discoveries are made or brought on stream. In fact, worries about tightening supplies are behind the recent rise in natural gas prices.

Why is this happening?

The Ladyfern discovery, made two years ago in northeastern B.C., was so prolific it kept overall Canadian production from falling off last winter. But it's running out faster than anticipated, with production expected to slow to a trickle by the end of next year. A big exploration rush in the same area has been largely unsuccessful.

Western Canada's remaining reserves are also being depleted at a rising rate. On average, natural gas fields are running out by more than 20% a year.

And new finds are, on average, not as significant as in the past.

"They are not as big, the initial production rates for a lot of wells are lower now than even last year or the year before," said Martin King, commodities analyst at FirstEnergy Capital Corp. "And decline rates for gas that is being found are higher now then they were a couple of years ago."

In the past few weeks, Talisman Energy Inc. and Canadian Natural Resources Ltd. warned they would not meet production growth expectations next year.

In the past, tightening supplies and the promise of higher prices provided all the motivation needed by oilpatch firms to look for new finds. But uncertainty in the markets has caused many to put drilling programs on hold, and use their cash to pay down debt.

Others have converted themselves into royalty trusts and distributed their cash flow to unit holders rather than looking for gas. And others are focused on integrating their operations after last year's consolidation binge.

(This week, Precision Drilling Corp., Canada's largest oilfield services company, said slower activity depressed profit by 70% in the third quarter. Chief executive Hank Swartout put some of the blame on the "trust frenzy" that reduced annual spending on oil and gas exploration and development by as much as $2-billion.)

Volatile spot prices haven't helped, either. Prices were soft through the summer as inventories stayed high on weak withdrawals and after coming off a warm winter.

Finally, weak demand because of the economic downturn has done its part to dampen exploration. "Gas is more price sensitive than oil. The loop works on the demand side and it translates into supply. If the price picks up, we will see a lot more activity and supply will come back," said Ed Peplinski, an analyst at Polar Securities Inc.

The result, according to Scotiabank's latest commodity price review, is that the number of active drilling rigs in the United States targeted toward natural gas has dropped 29% this year and in Canada by 28% -- "suggesting a sharp drop in natural gas deliverability."

"Natural gas prices are expected to climb substantially in the second half of 2003," the bank said, "alongside dramatically tighter supplies."

The search for gas is expected to recover in earnest by winter. But the consensus is that new gas won't be enough to offset reserve declines.

Steve Calderwood, analyst at Salman Partners Inc., said Canadian production won't grow again unless a big find is made. "If the basin was mature in light oil 20 years ago, it definitely is reaching maturity in natural gas now. The only commodity that is really showing significant growth is heavy oil, and that is under pressure because of Kyoto."

It's not as if there's a big inventory of known gas fields ready to be tapped soon. It could take until 2008 before a pipeline is built from the Mackenzie Delta. And the future of Deep Panuke, the next natural gas discovery in line for development off the East Coast, remains unclear. This week, EnCana Corp. said the project would not make its 2005 startup.

There's no question oil and gas companies and others in the industry love to paint alarmist pictures about future energy supplies. The more the market believes the sky is falling, the hotter prices get. And predicting natural gas prices is a difficult game because of their extreme volatility. Indeed, there were supply concerns at the start of last winter that turned out to be unfounded.

Yet the picture emerging this time points to another run of high gas prices, unless a new Ladyfern just happens to step forward.

ccattaneo@nationalpost.com