A recovery for natural gas prices in 2009 is unlikely, but as the rig count declines, it should set up supply to drop substantially at the same time the economy begins to recover, setting up a much more bullish 2010, Raymond James & Associates Inc. said Monday. The energy team predicted that gas prices could average $8/Mcf by 2010, well above its $5 forecast for this year.

Raymond James analysts J. Marshall Adkins, Wayne Andrews and Kristal Choy are looking beyond this year, but they found it difficult to look ahead without considering how much the exploration and production (E&P) and oil service indices were hammered in the last half of 2008.

“The S&P 500 decreased 39% in 2008, and the decline in oil and gas prices meant that E&P and oil service indices declined significantly as well (38% and 60%, respectively), despite their hefty gains during the first half of the year,” said Adkins and his colleagues. “This followed tremendous outperformance in 2007, with the indices up 42% and 51%. Likewise, alternative energy and coal stocks fell 70% and 63%, respectively, in 2008.”

As bears, Raymond James’ energy analysts were in the minority for U.S. gas prices in early 2008, even as gas prices rose, liquefied natural gas imports stalled, cold weather cut into storage and the deepwater Independence Hub gas platform was shut in for an extended period. Still, even with their bearish call for prices, “our 2008 gas forecast of $6.50/Mcf was too low by nearly 30%,” Adkins noted.

By mid-year, the gas market appeared to reflect the analysts’ concerns. And then came the market meltdown, which has lowered demand.

“On the North American gas side, we believe that the weakened demand outlook, on top of continued supply growth through the first half of 2009, will keep gas prices depressed through most of the year, bottoming in 3Q2009,” said the analysts. “As a result, our 2009 price forecast is $5/Mcf, which would be the lowest since 2002. While U.S. gas prices should remain weak through 2009, the massive decline in the rig count should eventually help balance the market,” which in turn should lead gas prices as much as $3 higher.

Even with the weakness in prices, the analysts see an upside for energy stocks. “We believe that energy stocks are, on the whole, still poised for gains in 2009,” Adkins noted. “Against the backdrop of a significant global economic slowdown, energy stocks should move higher due to demand resurgence as well as a strengthening oil market in the latter half of the year. Generally, we are looking for energy indices to be up 10-20%-plus, driven by the prospect of 2010 earnings growth and modest multiple expansion.”

Overall the E&P sector “is likely to be defined by volatility and mediocre average returns over the next 12 months,” wrote the analysts. “We project that the E&P Index will gain 10-15% in 2009, and similar to last year — but in contrast to 2006 and 2007 — stock selection will be essential under these challenging industry conditions. Against the backdrop of weak commodity prices (especially gas) and more modest growth rates than what many E&P investors have gotten accustomed to, key themes to focus on include (1) balance sheet strength and financial flexibility, including hedge positions and free cash flow potential; and (2) the ability to generate positive rates of return at sub-$60 oil and sub-$6 gas, a function of asset quality and cost structures.”

With the intermediate-term market volatility, most of the E&P stocks Raymond James currently recommends are oil-weighted producers. However, among gas-weighted producers, “selectivity is perhaps even more crucial given our bearish gas outlook.” Their top picks — Chesapeake Energy Corp., Comstock Resources Inc., Goodrich Petroleum Corp., Petrohawk Energy Corp. and Range Resources Corp. — “have significant resource play exposure that we believe can generate healthy returns even under our gas forecast.”

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