Lehman Brothers, SSB Say Storage is Fine, Others Show Concern

As the traditional storage withdrawal season came to an end last week with working gas near record lows at 627 Bcf (19% full) and 404 Bcf lower than the same time last year, there were mixed opinions on Wall Street about what the 2001 refill season might hold. Lehman Brothers and Salomon Smith Barney warned that storage might be refilled at a record rate this year, possibly prompting a bearish reaction in the market in the short-term despite the extremely low level of working gas currently. Meanwhile, UBS Warburg and IFR Pegasus said that scenario was very unlikely.

Lehman Brothers energy analyst Thomas Driscoll said the gas industry has reclaimed only a "small share of the demand" that was lost in December and January to energy conservation, alternative fuel sources and industrial production cuts. The demand loss has been "masked" by the cold weather experienced nationally that resulted in increased heating. The real signs of weaker demand will become evident within the next two months, he said.

Lehman Brothers lowered its 2001 benchmark natural gas price forecast last week for the second time in a month from $5.75 to $5.00/MMBtu because it sees demand down by 8 Bcf/d. The firm also predicted that storage injections could be 6-9 Bcf/d greater than last year's levels during the months of April and May, leading to the elimination of the current year-over-year deficit (at the time of the study) of 360 Bcf, unless prices fall enough to let demand recover sharply.

Driscoll said he believes that this year is going to be the opposite of 2000, and expects that the market is "set up for a sharp gas price drop." His report, however, was released before the American Gas Association announced last Wednesday that 49 Bcf was pulled from the ground during the last week in March, expanding the year-over-year deficit to 404 Bcf.

Analysts at Salomon Smith Barney (SSB) also predicted that lower demand because of high prices would lead to sharply steeper storage injections this spring. "Based on our assessment that domestic natural gas production continues to increase combined with the current level of incremental year-over-year fuel switching/plant shut-downs/conservation, but somewhat offset by lower hydro and nuclear supplies, we expect storage injections to initially embark on a pace 2-3 Bcf/d greater than last year, apart from influences due to weather," analysts at SSB said. "We would also caution that 'Chicken Little' may be lurking around the corner waiting to claim that 'the sky is falling' when it becomes clear that injections are strongly outpacing last year."

UBS Warburg's Ronald Barone disagreed, however, as he outlined his firm's prediction on the current storage situation after last week's AGA storage report. In a research note, Barone said as the industry enters the injection season with storage at only 19% full it will be a "tall order" to refill storage in the months ahead.

By UBS Warburg's tally, the industry would need to inject 71 Bcf per week in order to reach the 2,800 Bcf mark (85% full) by November, compared with the 56 Bcf average rate in 2000, and 62 Bcf over the past six years. "While the task of injecting 71 Bcf per week is not impossible (as suggested by the aggressive near-term demand destruction calls by some of our peers this week), we believe it is unrealistic," said the firm.

Barone's group said it is unlikely because of significant near-term nuclear shutdowns, feeble western hydroelectric supply conditions, high western gas-fired power utilization, the arrival of new gas fired generation nationwide, limited increases in U.S. deliverability and a weather outlook calling for warmer than normal Southeast and Western temperatures. Due to these factors, UBS Warburg said it is keeping its price forecast at $5.75.

UBS Warburg said considering the moderation in temperatures last week, and the fact that there was a 2 Bcf injection last year for the same time period, the company expects a "limited change" in the deficit after this week's announcement.

Lehman Brothers disagreed. "A continuation of recent demand patterns throughout the refill season would leave inventories at well in excess of 3,000 Bcf on October 31. We do not believe that inventories far above this traditional season-ending storage level of roughly 3,000 will be achieved; we expect gas prices to fall enough to restore natural gas demand. This is the reason for the decrease in our gas price forecast."

Tim Evans of IFR Pegasus said he was very skeptical of Lehman Brothers' forecast. He said it was "at odds with conventional wisdom," but "if they are right, they are geniuses."

"How rational would it be to expect [the year-over-year storage deficit] to completely disappear over a two-month period" Evans said. "So right off of the bat it is a tall order. My thinking here is that you have to walk before you run." If you look at "withdrawals over the past four weeks or so, you'll see that we are not making that much net fluctuation in the deficit." For the week that ended Feb. 2, the deficit was 426 Bcf, only 22 Bcf greater than the current 404 Bcf mark, Evans pointed out.

"So you have taken off 22 Bcf over the past nine weeks, and now they say you're going to erase 360 Bcf over the next nine weeks; I don't know about that," Evans said. "This would be a wonderful call on their part if it happened to be true because there is nothing in the flow of the data yet that would indicate that we are about to see this kind of a change in the rate of injection. Particularly when you would expect to see the flow into storage return to an average level from last year's low level as sort of an intermediate step, a transition to actually injecting into storage at a possible record high rate."

Also in its report, Lehman Brothers said it expects increased demand for natural gas due to power generation to add no more than 2-4 Bcf/d, and possibly much less depending on the weather and economy. Other than localized price spikes due to hot summer days, Lehman Brothers does not expect for there to be sustained high gas prices this summer as a result of power demand increases.

SSB agreed that there should be a significant increase in reliance on gas-fired power this summer compared to last because of low hydroelectric power availability and maintenance on nuclear plants. SSB analysts forecasted a slightly more conservative increase of 1.5-2.5 Bcf/d in gas demand for generation during the second quarter alone.

SSB analysts still believe, however, that market fundamentals will find a balance and will keep gas prices in the "$4-5/MMBtu range" throughout the summer. "The real test, and perhaps crucial catalyst for E&P stocks, could be the response in natural gas prices to the 'stress' that will certainly be exerted on the electric generation grid across the country this summer when temperatures soar."

However, the SSB analysts predict greater downside risk than upside potential over the next couple of months for E&P shares. The longer-term fundamentals "still bode well with valuations, on average, appearing to reflect no more than $20.00/bbl WTI spot crude and $3.50/MMBtu composite spot natural gas prices, respectively."

Lehman Brothers said with prices coming down, and storage working itself out of a deficit, it expects that exploration and production share prices could fall by 10-20% by the end of the second quarter. As a result, the firm lowered its ratings on Anadarko Petroleum, Apache Corp., Devon Energy and EOG Resources from "strong buy" to "buy."

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