Recent gas injection trends and a re-assessment of the reduced reward/risk profile of the oil and gas drilling sector have led analysts with RBC Capital Markets to assume a cautious stance on certain energy stocks through this year.

Analysts Kurt Hallead, Victor Marchon and Kevin G. Pollard said in their latest research comment that the oil service sector (OSX) “will trade in the volatile range over the summer.” This year, they said, “OSX stock performance could track the same pattern as 2000 when the group dropped less than 10% from June-October and rose more than 10% at the “tail end of the year.”

Natural gas injections for the last three weeks “have established new highs,” overtaking 2001 levels, they said. “For many investors, recent trends may bring back haunting memories of 2001 when injections reached new highs in 25 of the 33 re-fill weeks.”

However, while the RBC analysts said they don’t expect a repeat of 2001, they offered a “what if” scenario, suggesting that if injections match five-year highs between now and year-end, U.S. natural gas inventories will enter the 2003-2004 heating season between 2.9-3.1 Tcf. “This would put storage within earshot of the historical high level of 3.2 Tcf reached in 2001.”

In the past eight weeks, RBC’s Exploration and Production analysts estimate that natural gas demand destruction has averaged 3.1 Bcf/d, weather adjusted, versus 2.6 Bcf/d during the same period in 2001.

“Underscoring recent demand trends, fuel switching has become more prevalent as the spread between natural gas and residual fuel has increased to $2.12/Btu in June from $1.21 in January. The spread has not only widened, but, as important, natural gas prices have exceeded the $1/Btu switching trip point for six successive months.” RBC said that in 2001, the trip point was exceeded for seven consecutive months, “however, the spread declined from $4.85 in January to only $0.43 in June.”

Meanwhile, analysts noted that the OSX sector stocks are up 11% year-to-date and about 14% since the beginning of May. The RBC analysts “believe positive 2Q conference calls are largely priced into the stocks as many investors have been inundated with positive fundamental data and the concept of an unbreakable natural gas story. This is evident in that 23 of the 35 stocks in our coverage universe are within 90-95% of respective 52-week highs.”

Even though company fundamentals should be strong, RBC analysts “believe investors will become increasingly wary if recent natural gas injection trends continue. As such, we believe the probability of downside risk in the immediate term has increased.”

For the remainder of the summer, analysts said that it appears that Gulf of Mexico pricing and activity will moderate for the jackup and marine transportation market. Because of this, those companies operating in the sector will “likely perform in-line” with the sector until another pricing catalyst occurs. “Long-term fundamental trends remain intact but near-term momentum seems to have waned.”

Most likely, the rebound in the deepwater drilling market will occur in the second half of 2004 — not this year, as some had predicted.

The OSX companies covered by RBC are Halliburton Co., Lone Star Technologies, Nabors Industries, Noble Corp., Precision Drilling Corp., Schlumberger and Tidewater Inc. FMC Technologies and Oil States International Inc. also were mentioned by RBC analysts.

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