Analysts Lower Gas Price Forecasts, Shaky on E&P Segment

The near-term risk of more natural gas price erosion due to mild temperatures, high storage levels, the economic downturn and higher production levels across the nation led top industry analysts with Salomon Smith Barney (SSB), Lehman Brothers, ABN-AMRO, Simmons & Co. International, and Merrill Lynch to downgrade their 2002 stock price forecasts for several U.S. exploration and production (E&P) companies last week. Many of the same analysts also decided yet again to lower their respective 2001 and 2002 natural gas wholesale price outlooks.

The four investment banks firms that changed their forecasts posted new average spot wellhead price targets for 2002 ranging between $3.00/MMBtu and $3.75/MMBtu. That compared with old estimates that came in between $3.75 and $4.20. Merrill Lynch maintained its $4.25 outlook.

ABN-AMRO reported early last week that it was lowering its estimate of 2002 gas prices to $3.75/Mcf from $4.20/Mcf, but noted the new level "still represents a lofty and highly profitable commodity price for E&P companies."

Due to the large early season natural gas storage injections and the continued gas demand weakness in the industrial sector, analyst David Pursell of Simmons & Co. International said his research firm is revising its 2001 and 2002 price forecasts lower. For full year 2001, Simmons is dropping its estimate from $5.00/Mcf to $4.27/Mcf. He added that the company is also lowering its 2002 forecast from $4.20/Mcf to $3.50/Mcf.

Meanwhile, Lehman Brothers' Thomas Driscoll said he was lowering the company's 2002 and 2003 forecasts to $3/MMBtu, versus its previous forecast of $4/MMBtu in 2002 and $3.50/MMBtu in 2003. He also lowered his 2001 forecast for the rest of the year to $3/MMBtu, down from $4.10-$4.15/MMBtu.

Robert Morris of SSB, said that due "primarily to the demand side of the equation remaining more subdued" than originally anticipated, SSB recently decided to lower its full year 2002 composite spot gas price forecast to $3.25/MMBtu from $3.75/MMBtu.

"Although a rebound in the economy could put economic growth ahead of North American production growth in 2002, the stage is already being set for storage levels over the next 12-18 months to likely preclude composite spot natural gas prices from averaging much more than $3.25/MMBtu," Morris said in an SSB "Industry Note."

Donato Eassey broke from the forecast-reducing trend in Merrill Lynch's "Natural Gas Weekly Perspectives." He remains comfortable with his Henry Hub price projection of $5.00/Mcf in 2001 and $4.25/Mcf in 2002, despite Henry Hub spot prices falling 19.2% to $2.98/MMBtu versus $3.69/MMBtu the week prior. He said that even though gas prices are currently under downward pressure, residual fuel prices in the $3.25/MMBtu range should provide "resistance to lower prices, as fuel switching economics now favor gas for the first time in 12 months."

In his E&P "Flashnote," ABN-AMRO analyst James Whipkey said that their firm's decreased estimate reflected the "reality that current storage levels are 150 Bcf above those of last year," along with "looming sequential earnings declines, near-term risk of further natural gas price erosion and resulting multiple compression." Fellow ABN-AMRO analyst Eugene L. Nowak also lowered the forecast for several of the oil-heavy majors in the coming year because of lower natural gas prices.

Whipkey's forecast mirrors those of other analysts of late, noting that the sluggish demand for natural gas is making for a cloudy summer ahead. He revised his second-quarter figures in mid-June, forecasting a natural gas price of $4.25/Mcf. "While we are not yet retreating from our third-quarter forecast of $4/Mcf, we are going into the quarter significantly below that level of $3.25/Mcf, driven largely by the risk that storage may approach capacity by the end of the third quarter." The latest 2002 First Call consensus forecast is $4.10/Mcf.

Believing that natural gas is recapturing most of the demand it lost when fuel switching began in the first quarter of this year, the ABN-AMRO analysts still expect continued weakness in the price because of "general economic weakness and industry-specific shutdowns (i.e., fertilizer, aluminum, ammonia)."

However, a "bright spot" was found in their analysis of U.S. production, which they believe is not growing as much as the consensus forecast. "We expect data available in late July will indicate 2.0-2.5% annual production growth trend, driven largely by rate acceleration drilling. These low-risk infill programs are designed to extract known reserves more quickly in a high commodity price environment, at the expense of longer reserve lives and flatter decline rates."

Although production volumes from the low-risk infill programs will artificially inflate the perceived growth rate in second quarter 2001 numbers, ABN-AMRO found that the "illusion will be exposed when third quarter production figures are tabulated. At that time, we expect that a sub-2% U.S. production growth future gains credence, possibly fueling a share price rally as the traditional heating season approaches."

Although downbeat about current natural gas prices, ABN-AMRO analysts remain "solidly optimistic" about the E&P group values. "We remain convinced that long-term natural gas prices will remain above $3.50/Mcf for a variety of reasons," including:

  • Natural gas dominates the future electric power market;
  • Environmental pressure pushes users toward clean fuel;
  • Drilling rig infrastructure is already pushed to its limits;
  • Existing production decline rates are difficult to overcome;
  • Marginal cost of liquefied natural gas and Arctic gas demands a $3.50/Mcf floor;
  • Higher operating costs and acquisition costs raise the profit threshold; and
  • Generally poor domestic prospects are mismatched with future demand.

Earnings in 2002 for ABN-AMRO's universe of 13 E&P companies will "come in 27% below the 2001 numbers, and 2002 cash flow should be 15% below 2001. Year-over-year quarterly comparisons are also going the wrong way--while second quarter 2001 was nearly double second quarter 2000, we will start to see negative comparisons in the third quarter 2001 relative to third quarter 2000."

Analyst Whipkey reduced the investment ratings from "buy" to add" for several E&P independents, including Newfield Exploration, Evergreen Resources and Ocean Energy. They also moved Nuevo Energy to "hold" from "add."

In Lehman Bros.' E&P update last week, analysts Driscoll and Philip R. Skonick noted that strong natural gas storage injection rates "tell us that the market is oversupplied and that gas prices may need to fall." They said "if we continue to inject 4.2 Bcf/d more than the five-year average, we would reach a hypothetical 3,450 Bcf in storage at the beginning of November. This is about 450 Bcf greater than estimated target levels of about 3,000 Bcf."

Lehman Bros. analysts also believe that the gas market has recaptured most of the fuel switchers, and said that they believe gas liquids production "has partially recovered." However, they said they were "beginning to fear that the production response has been stronger than previously forecast," advising that both natural gas production volumes and imports were rising. "The recent high drilling activity levels appear to be generating a stronger than expected production response that will likely carry over to year-end and perhaps into next year," further eroding prices, the Lehman Bros. analysts said.

SSB's Morris said that the "road ahead for E&P shares still appears rough at this juncture" due to the year-over-year gas storage surplus. He said while SSB continues to see "at least 3.5% domestic natural gas production growth this year," demand has not returned at the levels it previously expected. Due to these factors, Morris said he believes storage levels will reach at least 3.1 Tcf by the start of winter compared with under 2.75 Tcf last year.

"Consequently, composite spot gas prices are not likely to be much over $3.00/MMBtu this fall and in the worst case scenario could approach $2.50/MMBtu, in our opinion," Morris said.

Regarding Morris' valuations on his coverage group, if spot gas and WTI spot crude oil prices are $3.25/MMBtu and $22.00/bbl, respectively, then Morris estimates that the upside over the next 12-18 months, on average, for SSB's coverage group is around 20%. However, if gas and oil prices are $2.75/MMBtu and $20.00/bbl, then the downside would appear to be around 20% on its coverage group.

With SSB's E&P composite currently off approximately 15% on the year, Morris said falling gas prices are to blame. The only catalysts Morris said he sees are an extended heat wave across the country or a sharp rebound in the nation's economy. "The biggest culprit underscoring the recent performance in E&P shares has been the collapse in composite spot natural gas prices, which broke the $3.50/MMBtu psychological barrier and ended the month [June] just under $3.15/MMBtu," Morris said in the update.

In Simmons & Co.'s "June 2001 Update," Pursell revised the third and fourth quarter 2001 price level from $5.00/Mcf to $3.00/Mcf and from $4.30/Mcf to $3.25/Mcf, respectively. The company noted that it still believes "that accurate and precise prediction of commodity prices is futile," and that it is not suggesting that gas or oil prices will revert to 1998 levels.

"The industry's apparent inability to substantially increase production has been more than offset by demand contraction during second quarter 2001 resulting in record storage injections," the Simmons' report stated. "Although our long-term view remains positive regarding natural gas, large early season storage additions will almost certainly result in high gas storage levels (approaching 3 Tcf) at the end of the summer injection period. Moreover, deteriorating U.S. manufacturing sector production has increased our degree of near-term caution, as this sector accounts for roughly one-third of U.S. natural gas demand. The macro-economic outlook is, and will continue to be the most important factor in the natural gas market in the coming months."

In Simmons' "Natural Gas Market Update," released on June 6, the company categorized reasons for the recent demand contraction and quantified the amount of demand lost. The company attributed 2-3 Bcf/d of lost demand came from fuel switching, 1 Bcf/d from mild shoulder period weather and approximately 2 Bcf/d from industrial demand weakness and conservation. Research the firm undertook revealed that through May 2001, the industrial sector capacity utilization was at lows not seen since the early 1980s.

The report was quick to point out that the revised forecast does not assume a "rapid rebound" in industrial manufacturing. However, it also does not assume the current pace of industrial weakening to continue over the next few months either. "The single biggest risk to our revised outlook is a continued deterioration of the underlying base industrial demand."

The Simmons report said storage injections during the month of June have in recent years been a "good proxy" for supply and demand fundamentals. With June 1999 and 2000 injections well below previous averages, the market signaled a tighter supply/demand balance.

"We have pointed to June 2001 injections as the touchstone of the current market fundamentals," the report stated. "With injections running well above average, it is clear the underlying fundamentals are weak...driven by demand-side response to high natural gas prices and a struggling U.S. manufacturing sector. We cannot ignore the large June injections, as they are the key reason for the reduction in our third quarter 2001 price outlook."

As for Eassey of Merrill Lynch, he remains slightly more positive than the rest with regard to what is to come. He said that while he understands that current prices will generate some downward earnings pressure on the universe Merrill Lynch covers, it will be "relatively minimal." Eassey said that his group's utility and merchant diversification provides a "shock-absorbing" function for the E&P units.

Labeling the long-term bullish gas cycle as continuing to remain "fundamentally intact," Eassey said in the near-term the more commodity-sensitive companies in its universe could remain under pressure through October, if hot summer weather fails to develop. "Nonetheless, we believe substantial value exists at current levels," the Merrill Lynch analyst said.

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