Analysts: Falling Gas Prices, Weak Demand Could Hurt E&Ps

Growing natural gas supply, combined with weak demand, is sustaining gas-price weakness, which may in turn lead to increased pressure on exploration and production (E&P) shares, according to energy analysts, who have warned that without a major event before the next heating season -- such as a hurricane in the Gulf of Mexico -- natural gas prices will remain low for several months.

Lehman Brothers analyst Thomas R. Driscoll said he remains "cautious" about the outlook for natural gas prices and E&P share prices, but warned that the near-term stock price performance for E&Ps "is likely to be negative." UBS Warburg analyst Ronald Barone, meanwhile, predicted natural gas pricing was in for a "rough, near-term ride."

SWS Securities analyst M. Bradley Davis, who is based in Houston, was more specific. "In the near term, we believe only a significant supply disruption, such as a hurricane causing Gulf of Mexico production to be shut-in and/or an early and cold winter, will have to occur in order to get market psychology to again turn favorable for natural gas pricing and cause the E&P sub-sector equities to move positively." However, he said SWS analysts "absolutely maintain our contention that with a normalized weather pattern, supply and demand are roughly in balance."

Last Wednesday, September natural gas futures dropped to their lowest level in more than two years, sent downward by a new report confirming ample U.S. gas storage inventories. September natural gas prices fell to an intra-day low at $2.25 on Nymex, which is its lowest level since April 1999. Wednesday's close found prices standing at $2.295/MMBtu, down 12 cents. October natural gas, the new near-month contract following September's expiration on Wednesday, also dropped by 5 cents to stand at $2.393.

Prices have fallen consistently since the American Gas Association (AGA) revised upward its storage inventory numbers in August (see NGI, Aug. 27). The AGA reported last week that gas storage levels rose 76 Bcf during the week ending Aug. 24. Total inventories now stand at 2,495 Bcf -- 16% above the level a year ago when AGA reported supplies at 2,144 Bcf.

Focusing specifically on the drop in gas prices and its effect on E&P stocks, Lehman Bros. analyst Driscoll noted that the "average E&P stock 'fairly' discounts a long-term natural gas price forecast of about $3/MMBtu," but he added that the fall in the September gas contract will put pressure on stock prices.

"U.S. wellhead natural gas production is rising at a 3-3.5% annual rate," said Driscoll.. By the fourth quarter, "we think that the year-over-year increase in U.S. production could be 4%, and that 2001 average production will be 2-2.5% above 2000 levels."

Add to that increased Canadian production, which he noted has increased an estimated 1.4 Bcf/d -- 9% in July alone. "Future production gains at Ladyfern (see NGI, Aug. 27) could yield an overall production increase...of more than 1.5 Bcf/d by the end of the year." Driscoll also sees a rise in the total supply available to U.S. consumers of as much as 5-7% more by the end of the year. "We are assuming that the majority of the Canadian production increase is destined for the U.S. market."

Working gas storage, which is "well above year-ago levels," with an increasing gap, is "now about 350 Bcf above year-ago levels and we think that the storage overhang will rise to 400-450 Bcf by the end of October," assuming that storage reaches 3,150-3,200 Bcf, and to 700-800 Bcf by the end of the year, assuming that normal weather leads to year-end storage of about 2,500 Bcf versus 1,729 Bcf at the end of 2000. "This excess inventory is equivalent to an estimated 3% of annual demand."

The Lehman Bros. analyst said the "surging gas supply could lead to a sustained period (months, not weeks) of gas prices in the $2-2.50/MMBtu range," adding that "investors may have underestimated the strength and sustainability of the natural gas supply rebound." Driscoll said, "Investors should not have been surprised that the recovery in drilling activity levels from the sub-400 gas rig count and the plummeting production environment of early 1999 did not lead to a quicker upturn in production."

As expected, said Driscoll, "production turned upward...about three to six months after the gas rig count reached our estimated 'equilibrium' rig count of 700 rigs drilling for gas." Now, the estimated "equilibrium" level has doubled, and "will likely continue to increase 3-6% per year in the near term."

In turn, gas price forecasts "are likely to decline," said Driscoll, and "over the next several weeks, we expect many investors to lower gas price forecasts for the remainder of this year and to perhaps lower 2002 gas-price forecasts as well." Third quarter natural gas prices (bidweek close) will average around $2.90/MMBtu, he said, down from the analyst's previous 3Q estimate of $3/MMBtu. While still maintaining a fourth quarter and 2002 gas price forecast of $3/MMBtu, Driscoll said "we could prove to be over-optimistic."

SWS analysts believe that the "near-term floor for natural gas prices will be in the $2.25-2.75 range (by near-term we mean over the next 60-90 days), taking into account the continuing absence of hot weather...the lost confidence in AGA reporting accuracy, uncertain economic conditions and no tropical storm activity on the horizon...We continue to expect lots of volatility," said Davis.

UBS's Barone predicted natural gas pricing won't gain in the coming weeks because "basically, summer is over...Given overall mild national temperatures this week (along with a 42 Bcf injection comparison), we would expect moderate growth in the surplus upon the release of the next American Gas Association report." Barone said UBS calculations suggest a "going-forward weekly injection requirement of 51 Bcf (or 7.2 Bcf/d) to reach 3 Tcf by Nov. 1 and 72 Bcf (10.2 Bcf/d) to reach 3.2 Tcf."

Said Barone, "with August likely to come in near our $2.90 assumption (and a tweaking of monthly assumptions over the balance of the year), our $4.10 forecast should be able to withstand this turbulence. However, if the industry approaches November with supplies north of 3,200 Bcf (and there is any delay in the arrival of heating loads), our forecast could prove aggressive."

With the end of a "prolonged period of pummeling from ever-deteriorating storage psychology," Barone said that "the crippled September 2001 futures contract" -- which expired at $2.29/MMBtu on Wednesday -- and noted that the 12-month strip was now trading at $2.96 versus $3.31 a week ago and $4.33 a year ago. "Spot price deterioration continues with the 12-region composite poised to test the psychological $2.50/MMBtu level."

The latest figures also won't materially change the markets and the "recent apathetic-to-negative view toward either natural gas pricing or exploration ad production sub-sector equities," said Davis of SWS. He noted, however, that investors should continue to buy E&P stocks "on strong pullbacks, with one eye on building a longer-term position, and the other eye on the possibility of selling positions to catch share price appreciation later this winter."

Driscoll, who noted that "this has frequently been a dangerous time of year to own oil and gas producers' shares," said that during the entire 1990s, E&P shares underperformed the Standard & Poors index by an average of 20%/year over the six months from the end of August to the end of February. He added, however, that E&P shares are, on average, at "fair value" today, and "if we are correct and investors 12 months from now are willing to believe that our oil and gas price forecasts are correct, this 'value-buyer' should be rewarded with [an] approximately 20% annual return."

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