It’s not happy post-holiday news for natural gas bulls when a pair of analysts write in their first market note of the year that their 2007 outlook “has deteriorated substantially from what we were expecting just a few months ago.”

Raymond James & Associates Inc. analysts cut sharply their 2007 U.S. natural gas forecast from $10 to $7.50 on a so-far disappointingly warm winter and high natural gas stocks that could rival levels seen still in storage at the end of last winter when all is said and done.

With the New Year’s confetti only just swept up, Raymond James as well as SunTrust Robinson Humphrey/the Gerdes Group are writing off the first half of 2007 and already looking to 2008 for price strength.

“Unfortunately, we are nearly half-way through the winter and the weather has averaged over 15% warmer than normal (on a degree day basis) and we have already lost 250 to 350 Bcf of gas demand due to warmer-than-normal weather,” wrote Raymond James analysts J. Marshall Adkins and Wayne Andrews in their Wednesday Stat of the Week. “Of course, it is possible that the second half of winter could average 15% colder than normal, but that is not a statistical bet that we want to make.”

What might not be a bet for analysts could be a prayer for energy sector investors, who this year saw returns from dollars invested in the energy patch greatly diminished.

For the first time in five years the closing price for both oil and natural gas on the last trading day of the year was below the previous year’s close, noted Phil McPherson, an analyst with C.K. Cooper & Co., in a research note Wednesday. “Not since 2001 when natural gas closed at $3.42, down from $5.77/Mcfe in the previous year, have energy investors been faced with lower prices for year-end reserve reports.”

The firm’s peer group of 20 small-cap exploration and production companies posted an aggregate return of 5%, the lowest return in five years. “The dominant theme for this mediocre perofrmance is pretty clear: just look at where natural gas prices have gone, down!” McPherson wrote.

With the mild winter and abundance of gas in storage, gas prices could average $7.00/ Mcf for 2007 and could dip as low as $5.00/Mcf if winter temperatures remain warm, the analyst wrote.

Last winter ended with a record 1.7 Tcf still in storage, the Raymond James analysts noted, and this year could see storage levels on March 31 just as high unless cooler-than-normal weather shows up, which, of course, is possible. A winter’s end with bloated inventories will likely weigh on prices for the entire year, as happened in 2006, even though last summer was “substantially warmer than normal,” the analysts noted.

Lacking cooperation from Mother Nature, the analysts look to drillers and a curtailment of their activity for price support during the second half of 2007. “Our average $7.50 forecast assumes that gas prices gradually improve through the year as natural gas supplies respond to less drilling activity in both the U.S. and Canada.”

The new Raymond James forecast for Henry Hub prices by quarter for 2007 is $6.50, $7.00, $7.75 and $8.75, consecutively, down from the previous across-the-board forecast of $10.00. For 2008 the firm is projecting $10.00 across the board at Henry Hub.

For equity investors, the first-half commodity price weakness and any associated stock price softness offer a buying opportunity, noted John Gerdes, analyst with SunTrust Robinson Humphrey/the Gerdes Group. “Beyond the vagaries of anomalous winter weather and elevated gas inventories, U.S. natural gas prices need to average $8-9 long-term to provide the price environment necessary to maintain overall North American gas supply and attract a reasonable percentage of the growing LNG trade,” Gerdes wrote in his Wednesday “Energy Insight” note.

Gerdes said the domestic exploration and production (E&P) sector is roughly free cash flow neutral at $8.50 gas and $65 oil with current costs and spending levels. Hence, an expectation for the long-term drilling needed to maintain North American gas supply requires $8.50 gas and $65 oil. However, the stock valuations of the firm’s portfolio of producers reflect prices of $7.60 gas and $65 oil. For this reason, Gerdes wrote, “[f]rom a macro perspective we generally favor gas versus oil-weighted E&P names.”

Gerdes has a $7.75 gas price expectation for 2007. “Assuming the weather remains extremely mild, gas prices could indeed average as low as $7 this year; however, in that price environment, the U.S. E&P industry would be almost 30% free cash flow negative given current cost and capital spending/activity levels,” Gerdes wrote.

So, look for at least a 10% reduction in U.S. E&P activity. A similar reduction already is occurring in Canada where producer margins are about 20% inferior to those of U.S. companies, Gerdes noted. [Last week, Canaccord Adams analyst Irene Haas talked with NGI about Canadian production declines and their impact on the United States (see Daily GPI, Jan. 2)].

“A 10% reduction in U.S. gas drilling activity and probable further decline in Canadian gas drilling activity would almost assuredly lower U.S.-directed supply to sufficiently underpin at least $7 gas prices regardless of ’06/’07 winter weather,” Gerdes wrote.

McPherson seems to agree. “We have repeatedly expressed our concern that basing investment decisions on an $8.00 natural gas deck is recipe for disaster,” he wrote in his research note. “We continue to believe that natural gas will average $7.00 per Mcfe for 2007. However, there is a high percentage chance that if warmer weather persists, natural gas will again touch the $5.00/Mcfe level.”

For their part the Raymond James analysts wrote that their $7.50 forecast assumes prices improve through the year as supplies respond to decreased domestic and Canadian drilling activity. “Looking out beyond 2007, we expect to see continued 1% to 4% annual declines in domestic gas production for the foreseeable future, despite likely increases in 2008 capital budgets and drilling activity,” wrote the Raymond James analysts.

Demand through 2008 will rise steadily on the back of economic growth and electric generation demand, and given this, Raymond James initiated its $10 forecast for 2008 and noted weather-related (i.e., hurricane) spikes are possible over the next 12 to 24 months. The Raymond James forecast is $2.47/Mcf (33%) above consensus and $2.04/Mcf (26%) above the futures strip.

For equity investors, the Raymond James analysts said that despite the expected poor performance of natural gas prices, energy stocks are still in line for modest gains during the year. “Simply put, the energy stocks in 2007 will be priced upon what we think is an increasingly bullish energy outlook for 2008.”

©Copyright 2007Intelligence Press Inc. All rights reserved. The preceding news reportmay not be republished or redistributed, in whole or in part, in anyform, without prior written consent of Intelligence Press, Inc.