The recent resurgence of price-sensitive demand through fuel switching, liquids stripping and what may prove to be "gas on gas" competition at current price levels could translate into a bottom for natural gas prices in the $6/Mcf area -- not the market's perceived $4-$5 range -- Raymond James analysts said in an energy note on Monday.
Market sentiment surrounding the overall energy complex, especially natural gas and gas-levered stocks, "has been about as ugly as we have ever experienced," said analysts J. Marshal Adkins and Darren Horowitz and research associate Parag Sanghani in their Stat of the Week. "With the market refocusing its attention on the current bloated year-over-year natural gas inventory picture and its potential impact for an over-full, summer-ending storage situation, gas bears have thrown in the towel on natural-gas levered stocks."
But the analysts said they believe the futures market is "telegraphing a crucial message to the stock market that the gas bears do not see -- today's low prices are sufficient to rebalance the gas equation before the winter begins. While our summer-ending gas storage estimates are not exactly table-pounding bullish, they are much more bullish than current consensus stock market views. The key difference, in our opinion, is that most analysts are underestimating the amount of gas demand destruction that occurred after the hurricanes caused gas prices to spike last fall. That means year-over-year gas storage comparisons should look much better than the market thinks in September and October of this year. In other words, we believe the gas futures strip will prove to be more right than the stock market is currently forecasting."
The analysts noted that in the past month, the Oil Service Index has retraced about 15% from its intraday high of 238.82 on May 11. "While we acknowledge the possibility of a summer U.S. gas price collapse, we think the stock market is pricing in a very high probability of a gas problem. We think the risk to gas is way overstated."
In the month-long pullback, most of the investors Adkins and his group have spoken with now assume storage levels will reach 3.9 Tcf at the end of October. According to NGI's storage database, total U.S. working gas capacity in 2004 was only 3.7 Tcf so it's unclear if reaching 3.9 Tcf is even possible. "Since there is probably not enough storage capacity to hold this much gas, consensus expectations are that gas prices must move low enough to force producers to shut in gas wells sometime this summer. According to most investors that we have spoken with, this 'gas on gas' competition would likely drive cash prices into the $4/Mcf to $5/Mcf range before producers begin to shut in gas production."
The Raymond James summer-ending gas storage estimates are "by no means bullish" relative to historical storage levels. But they are much more bullish than current consensus expectations.
"Specifically, we believe that a resurgence of price-sensitive gas demand (fuel switching/liquids stripping, etc), and/or production shut-ins at current gas price levels, should leave us with ending gas storage levels closer to 3.5 Tcf at the end of October. If our estimates are correct, then the year-over-year surplus of gas storage should shrink from a nearly 500 Bcf surplus to only a 300 Bcf surplus by the end of the summer. This may not seem like a huge improvement, but it is important to remember that gas price changes are highly correlated with directional changes in the year-over-year storage differential."
The forecast "represents a meaningful directional change in the gas storage surplus that could indicate that U.S. gas prices have seen a bottom for the year. Most analysts estimate summer-ending storage levels by taking current gas inventory levels and applying five-year injection averages to arrive at a summer-ending estimate. Using that math, we would end the summer at an unprecedented 3.9 Tcf in storage. We doubt this is even feasible. Even if we take last summer's gas injections (keep in mind we had the hurricanes and warmer than normal temperatures), we end up with a whopping 3.7 Tcf in storage...either one of these ending levels would be the disaster that the stock market is currently anticipating."
The stock market, said the analysts, is underestimating the amount of gas demand that was destroyed after the hurricanes and the amount of demand that will return (or supply that will be shut in) at current prices.
Adjusting the weekly gas storage data for weather differences, the Raymond James analysts said that beginning in June 2005, the year-over-year gas supply/demand equation began to tighten. By August 2005, there was about 2 Bcf/d less gas available for storage than in August 2004 (excluding weather differences). And the hurricanes last summer knocked out about 5.5 Bcf/d of gas supply in September and October.
"Of course, if that were the only thing that changed, our supply/demand equation should have tightened further to around 7-8 Bcf less gas available for storage than the prior year." But the opposite happened. "Instead of getting tighter with the lost supply, gas supply/demand actually flipped to 2 Bcf/day looser than the prior year. So what happened? The implication from this data is that some 9-10 Bcf/day of gas demand was destroyed relative to last year. It is also important to note that the demand that we lost last fall/winter has begun to show signs of recovery. Using a four-week moving average of gas storage data, we are now seeing a tighter gas market than at the same time last year. Since supply probably has not changed dramatically over the past few months, it is reasonable to assume that gas demand is returning with these lower gas prices."
Department of Energy (DOE) data indicated similar, although less severe post-hurricane demand destruction. The Energy Information Administration's gas demand estimate for August 2005 "was about 1.2 Bcf/day higher vs. the previous year (adjusted for weather). Following the impact of Hurricanes Katrina and Rita, demand decreased to a year-over-year loss of 3.65 Bcf/d for the months of September and October, on average." The impact indicated a swing in demand of almost 5 Bcf/d from August to September/October 2005.
"Whether you use our year-over-year comparison analysis or the DOE data, it is clear to us that there was more demand destruction after the hurricanes (due to both infrastructure damage and higher prices) than there was supply destruction. We do not think that most energy investors understand this fact."
The analysts said they believe net gas supply will not be "meaningfully different" than last summer because increases in liquefied natural gas and land-based production will be offset by lower offshore production; economy-driven demand and price-induced fuel switching/liquids stripping will increase base demand by about 2 Bcf/d over last summer (crude:gas ratio was 7.5:1 last summer while it is closer to 12:1 today); assuming normal weather and no hurricanes, there should be about 100 Bcf less gas demand and 345 Bcf more gas supply than last summer; and between 5-9 Bcf/d of demand that was lost in September/October 2005 will be back in the system this September/October.
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