Investors looking for a rise in exploration and production stocks will be “climbing a wall of worry” at least in the near term, according to FAC/Equities analyst Robert Christensen Jr. There are so many negatives, including packed gas storage inventories, no winter weather to speak of, and low oil and gas prices. But the plummeting rig count and declining production point to a turnaround by the middle of 2002, he said.

“In our opinion, this is a market that knows all the negatives…yet can brush these influences aside and look to a slew of fundamental positives in the second half of 2002,” said Christensen, noting his expectation for a 6% drop in wellhead deliverability next year and a substantial economic recovery that will boost demand. He believes investors can look past near-term fundamentals and buy up E&P stocks at these price levels.

Lehman Brothers analyst Thomas Driscoll, however, urged investors to approach the shares of exploration and production companies with much more caution in the near term. “Over the next several months we believe that spot natural gas prices are likely to average $1.75-2.25/MMBtu — far below the $3.00-3.25/MMBtu long-term price that we believe is reflected in share prices.” Driscoll said he thinks a “meaningful recovery” in prices is unlikely to occur before mid-year 2002 as production falls and the economy recovers.

He is downgrading the shares of EOG Resources (EOG) from 2-Buy to a 3-Market Perform and is maintaining a 3 code on several other large producers, including Burlington Resources (BR), Devon Energy (DVN) and Anadarko Petroleum (APC).

Excess gas inventories will continue to depress gas prices in the near term, he said. “We expect the storage ‘gap’ to reach 525-550 Bcf versus five-year averages by mid-December and that the ‘gap’ versus last year will approach 1,000 Bcf by yearend. Typically demand totals about 70-75 Bcf/d during Q1 — the storage overhang versus five-year averages means that an additional 5.5 Bcf/d (7.5-8% of expected Q1 gas demand) of natural gas will be available to consumers in Q1. Prices could easily remain below $2 for a period of time.”

Storage withdrawals have been substantially below historical averages this heating season — even adjusted for the weather. Driscoll said withdrawals have been 2-3 Bcf/d less than the five-year average for November. Over the past four weeks, the industry has injected 1 Bcf/d into storage, compared with a five-year average withdrawal of 7.3 Bcf/d over the same four-week period. According to Driscoll, warm weather (158 fewer heating degree days than the five-year average) accounted for 5.6 Bcf/d of the 8.3 Bcf/d swing in net injections. “Thus the market appears to be 2-3 Bcf/d less tight than it was over the past five years on average,” he said.

Another factor that will “keep a lid on natural gas prices” this winter is low oil prices. “Energy consumers, rather than natural gas producers, that can switch to residual fuel oil can take comfort from the recent drop in oil prices. Natural gas producers lost an estimated 1.0-1.5 Bcf/d of demand to consumers that were able to switch to less expensive residual fuel oil during the first eight months of 2001. Until the natural gas market tightens enough to allow the gas markets to balance without these consumers, we think that spot gas prices could be capped at $2.00-2.50/MMBtu.”

Driscoll believes some analysts recently have made a mistake in raising their price forecasts because of quarterly production declines. Gas production was estimated to be down 1.5% in the third quarter from second quarter levels, which led some investors to lower forward production estimates and raise long-term price forecasts.

“We would point out that Q3 volumes are normally seasonally weak (we estimate that Q3 volumes have fallen by an average of 1.0% over the past five years),” said Driscoll. “While Q3 production was significantly lighter than our revised forecast (our model forecast of a 0.3% decline), we are hesitant to forecast future production trends based on Q3’s experience.”

While Driscoll predicts production will be flat to up slightly in the fourth and first quarter, he does believe a decline will begin to set in during the second quarter of next year as the impact of a 25% decrease in drilling begins to take effect. Lehman Brothers’ most recent forecast showed a 17% oil and gas production increase in 2002 for a 30-company universe. However, that prediction likely will change in the coming weeks, said Driscoll, as companies begin to warn investors that they are expecting lower production levels than previously estimated for 2002.

“We expect oil and gas producers to guide investor expectations down over the next several months,” he said. “As an example, Kerr-McGee recently reduced its 2002 production guidance by about 10% and it introduced 2003 production guidance that showed no growth from 2002 volumes. A portion of the reduction in expectations was attributed to the lower cash flows and lower cap-expenditure plans that resulted from falling oil and gas prices. We would guess that our production forecasts are likely to come down by an average of 2-4% over the next 60-90 days.”

Earnings estimates are coming down, too. “We expect Q4 EPS [earnings per share] to be only about 20% of Q3 EPS and about 15-20% of Q4-00 earnings,” said Driscoll. “For 2002, we are forecasting an average EPS reduction of roughly 80% from 2001 levels.”

FAC/Equities’ Christensen believes the plummeting rig count will eventually be “greeted bullishly by investors.” He sees wellhead deliverability down 2% by mid-2002 and down 6% by the end of 2002, while he expects demand to rebound next year as the economy recovers.

“On average we see 24% potential appreciation in [producer] group stocks by late 2002,” he said.

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