Based on the recent resurgence in the U.S. economy and the technical gas futures rally sparked in part by a surge in oil prices, Salomon Smith Barney (SSB) analyst Robert Morris has raised his natural gas price forecast for 2002 and 2003, joining the ranks of other investment analysts. Earlier last week, Raymond James & Associates analyst Wayne Andrews cited stronger supply-driven fundamentals as a reason for his more bullish near-term gas outlook for higher prices during the second and third quarters.

Ensuring that its report was not some kind of April Fools joke, Andrews said that initial results from a first quarter 2002 U.S. natural gas production survey revealed an alarming trend. The survey found that U.S. natural gas production is not only declining sequentially for the third consecutive quarter, but also that this gas production decline is accelerating.

In the Raymond James’ Stat of the Week, Andrews said that stronger supply-driven fundamentals for natural gas provide a more bullish near-term outlook and should support higher natural gas prices during the second and third quarters. As a result, the group is raising its second and third quarter 2002 price forecasts from $2.80/MMBtu and $3.65/MMBtu to $3.50/MMBtu and $3.75/MMBtu, respectively. This increases its full-year 2002 Henry Hub natural gas price forecast from $3.25/MMBtu to $3.45/MMBtu. Raymond James’ survey covers 30 of the largest U.S. natural gas producers (representing nearly 45% of U.S. production).

SSB also raised its forecast. “We are raising our 2002 composite spot natural gas price forecast to $ 2.85/MMBtu from $2.25/MMBtu, and for 2003 to $3.50/MMBtu from $3.00/MMBtu,” Morris said in SSB’s Natural Gas Price and Exploration & Production Sector Update. The revised forecast assumes $2.39/MMBtu in the first quarter, $2.75/MMBtu for the second quarter, $3.00/MMBtu for the third quarter and $3.25/MMBtu in the fourth quarter.

“While we have not changed our views on the supply side, the uptick in projected demand given recent increases in SSB’ s 2002 U.S. GDP growth forecast has tightened the outlook for next winter and into 2003,” Morris added. “Based on our current 2.9% U.S. GDP growth forecast this year (up from 1.4% last September), we still expect gas storage to approach the ‘normal’ level by the start of winter, although the projected range is now 3.0 to 3.1 Tcf.”

As of the end of the traditional withdrawal season, according to the report last week by the American Gas Association, working gas levels in storage stood at 1,424 Bcf, representing a year-over-year surplus of 804 Bcf.

In addition to the surge in oil prices that helped to fuel a technical rally, SSB said the speculation on possible nuclear plant closures and other variables has put natural gas prices “ahead of the fundamentals” for the moment. Despite the current conditions, Morris said he believes that the market has begun to look ahead to the impending tighter future supply/demand balance in driving much of the recent rise in gas prices.

“We would also note that while we believe the longer-term ‘normalized’ composite spot natural gas price should be around $3.25/MMBtu based on the delivered price required for new LNG import facilities, significant incremental capacity won’t likely begin to be available until late 2004/2005,” Morris said. “Thus, natural gas prices could average higher during this interim period, especially if next winter is much colder than normal.” He added that SSB continues to believe that the longer-term fundamentals for natural gas are solid.

The two investment houses agreed that preliminary data from the first quarter of 2002 shows a decline in domestic natural gas production, but disagreed on how much it was down. Salomon Smith Barney’s aggregate projections for 40 of the largest public natural gas producers reveals that first quarter 2002 domestic gas production should be down by 0.3% compared with the fourth quarter of 2001, while the company’s proprietary deliverability models indicate a sequential drop of approximately 0.5%.

Raymond James found a much larger decline. “Specifically, our preliminary survey shows that first quarter U.S. natural gas production declined by 1.8% from the fourth quarter of 2001,” Andrews said. “This is significantly higher than the 1.3% sequential decline from the third to fourth quarter in 2001. Additionally, on a year-over-year basis, U.S. gas production is projected to be down by 2.9% in the first quarter of 2002. Based on these numbers, it appears that supply is declining much faster than most have expected.”

Despite the bullish outlooks by analysts, energy consultant Ron Denhardt with Wefa Inc. said that he believes prices can not sustain their current levels.

“There are two conflicting signals that are going on right now,” Denhardt said. He pointed out that working gas storage withdrawals per degree day have been running extremely high. “What that means is either there is a lot more demand out there than people expected or there is a lot less [gas] production.” Denhardt believes one of the reasons for the high storage withdrawal per degree day is maintenance on power plants. Since power prices are currently down, it is a good time to bring plants offline to perform deferred maintenance.

“My gut is that the market is over-priced,” Denhardt said. He added that it is difficult to say what is currently happening because a lot of the data for the first quarter has not come out yet. “We just don’t have a good sample yet.” He said that current prices also make LNG imports economical. “At these prices, you import everything you can.” But, “it is hard for me to see that the market can support even the current level of prices given the kind of demand responses you’re likely to get from these prices. Now there is something going on that is making the current supply/demand balance very tight and if that persists, I will be wrong.”

Allowing that many analysts expected some decrease in U.S. production during the first half of 2002, Andrews said that few have predicted such a steep sequential decline (1.8%) in the first quarter. Instead of following the typical U.S. gas production trend of lagging the rig count by some three to six months, U.S. gas production in 2001 actually began showing declines before the peak in drilling activity in July, the group said. As a result, “we expected to see sequential declines of approximately 1.5% per quarter in 2002, which looks to be right on the mark and could even turn out to be too conservative.”

“We believe the rigs that have been stacked are the ones that were actually drilling the high flow rate, short-life wells with economics that are very sensitive to short-term commodity price swings (such as the Gulf of Mexico Shelf and Bossier plays),” Andrews said. “In other words, producers were drilling wells that they could bring on production quickly at high flow rates in an effort to capitalize on the pricing environment for natural gas at that time. With activity on these types of prospects halted, production from these projects will likely be down by as much as 30-40% in 2002.”

As a result, the group said that sequential production declines should continue to gain momentum as the year progresses, and U.S. natural gas production could be down by as much as 5% to 6% this summer on a year-over-year basis.

“Even though the gas markets and the energy stocks are currently being driven by expectations for recovering demand, we still think lower supply will ultimately be the real driver of a bullish gas market. Consequently, due to the larger-than-expected decline in U.S. production evident in our survey, we are taking a more bullish near-term view on natural gas prices.” In addition to revising its 2002 price forecast upward, the group said it also is taking this opportunity to introduce its 2003 price forecast of $3.75/MMBtu, as Raymond James remains “decidedly bullish” over the longer term as well.

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