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Energy Analysts Forecast Continued Financial Restraint by Producers, More International Expansion

Energy Analysts Forecast Continued Financial Restraint by Producers, More International Expansion

Financial analysts see a sharper focus this year on reserves accounting systems, continued financial restraint and more international expansion by exploration and production companies, with perhaps a few mergers and acquisitions between integrated companies and refiners. However, less is certain about the status of North America's natural gas resources, as producers continue to make discoveries but fail to grow production.

For the past few days, several energy analysts have been offering their take on 2004 for the oil and gas sector this year. Most see a growing natural gas demand and dwindling supplies that will continue to push prices to high levels in the United States, but analysts are moderate in their price forecasts. Overall, $6/Mcf gas prices are forecast to be unsustainable over the long haul, but most agree that gas prices will remain higher than $4/Mcf for the next several years.

Sean Sexton, senior director at Fitch Ratings, said Wednesday that for natural gas, "concern looms over declining North American production and is reflected in longer term natural gas futures prices." However, he added that again, winter weather will dictate the robustness of natural gas prices short term. "Given the concerns regarding production, prices will continue to be very volatile over the intermediate term, with most of the volatility being on the upside benefiting producers," said Sexton.

At current oil and gas prices, Raymond James' analysts said producers are "poised to exceed" fourth quarter estimates and "deliver very impressive first quarter financial results" if gas prices remain above their current $5.75/Mcf and $31/bbl first quarter estimates. And, "given the relatively low level of hedging for the year, the group is well positioned to benefit from continued price strength. Conversely, most companies are only modestly protected should prices retreat."

Gas prices more than likely will retreat this year, according to RBC Capital Markets analysts. "We think that once the market accepts that gas storage is likely to wind up at a comfortable level, gas prices will decline further, possibly into the low $4s." RBC is forecasting that gas storage to be at 1.2-1.3 Tcf by the end of the heating season on April 1. "With only 12 storage reports left in the heating season and a current storage surplus of 184 Bcf, it would take withdrawals of more than 15 Bcf/week, or 2.2 Bcf/d, just to get down to normal storage levels."

Even with more moderate gas prices, however, analysts see strong cash flow for producers in 2004. Fitch's Sexton said cash flow should "exceed necessary maintenance capital in 2004," but "we suspect a lot of the incremental cash flow will be directed toward dividend increases and stock repurchases, rather than for debt reduction, since most companies are already at their targeted capital structure."

CreditSights analysts also expect to see continued strong cash flow generation this year, however, unlike Fitch, they expect any extra cash to flow toward the bottom line.

"We expect companies to maintain capital discipline and balance sheet strength by keeping capital spending within cash flow levels," said CreditSights analysts Brian Gibbons Jr. and Spencer Siino. "As the broad market continues to recover and overall credit conditions improve, we believe the sector will be a relative underperformer in 2004."

Especially for the integrateds, CreditSights said the group "to continue to prune high cost, low growth upstream properties in mature basins. Capital discipline as it relates to capital spending and balance sheet maintenance will continue to be the mantra coming out of managements, however we expect modest debt reduction as companies focus on share buybacks and dividend increases."

On the production side, CreditSights also is forecasting a continued struggle by exploration and production companies to grow domestic production, because costs continue "to creep higher as producers tap unconventional plays and new geologies (coalbed methane, tight gas, deep wells)." Analysts said that international expansion "will be a key theme and this will likely be the key driver" behind any merger and acquisition (M&A) deals.

"M&A activity among the large caps is unlikely given the maturity of the North American supply basin and judging by companies' focus on increasing international activity," said Gibbons and Siino. Long-term winners, they said, will be those companies focused on international gas expansion, including Apache Corp. and Unocal Corp.

However, production goals should be met this year, said Gibbons and Siino, because "companies re-adjusted their growth estimates in 2003 following a disastrous 2002, which witnessed one production miss after another."

Supply-wise, analysts believe imports are only part of the U.S. solution, but Canada, its largest importer, also is experiencing supply dips and increased demands, which leaves less supply for export. Liquefied natural gas (LNG) supplies amounted to 1% of U.S. demand last year and are not expected to grow to more than 5% of demand until around 2010.

Oil and gas reserves accounting "likely" will come into sharper focus, they said, because of Royal Dutch/Shell Group's recent 20% negative reserve revision announcement. And, the analysts also see unit cost structures continuing to rise "despite efforts to high-grade portfolios with the simple truth being there remain fewer and fewer easy, low cost finds in the world. "

Refiners also are continuing to strengthen their balance sheet, "which are the healthiest they've been since 2001. Merger and acquisition (M&A) activity is likely to come from Refiners picking off integrated assets set for divestiture and niche refineries from small players unable to meet new Tier II specifications."

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