From TSC:
Is there a bearish case to be made for natural gas?
I'm still cautious in the short term and constructive longer term on the price for natural gas and the prospects for natural gas exploration and production, or E&P, companies. But there's an analyst with a solid track record that says that rosy outlook may be overdone.
Tom Driscoll at Lehman Brothers sees warning signs of weakness for gas prices and E&P stocks.
"Natural gas prices have fallen sharply over the past two months as evidence of surplus gas and a dramatic increase in storage injections has accumulated," Driscoll wrote in a note to clients on Tuesday. "Despite plummeting natural gas prices, E&P stocks, after falling sharply in March, have rallied sharply off of the early April bottom. We believe that further weakness in natural gas prices could cause E&P shares to fall over the next 90 days and we remain cautious on the shares."
Supply . . .
The primary reason for Driscoll's cautious stance are recent reports of strong gains in natural gas storage. After a winter where most industry pundits expressed concern over a shortage of gas, the annual "refill season" -- the period beginning in late March, after the winter heating season, where natural gas storage tanks are replenished -- has dramatically exceeded expectations.
This year, injections of natural gas into storage -- about 10.7 billion cubic feet per day, or bcfd, -- have averaged more than three times last year's levels and 65% above the average of the past seven years. In addition, new exploration and production efforts are slowly coming to market. Data show "production volumes increased 1.3% compared to [fourth-quarter] levels and 0.6% compared to year-earlier levels," Driscoll noted. "Reported production volumes showed sharp declines in early 2000. Production then began to increase slowly later in 2000."
That leads Driscoll to suggest strong storage may exert even more pressure on natural gas prices. "Once storage levels match year-ago and five-year average levels, we expect the strong support that natural gas prices are getting from storage purchases to lessen."
. . . And Demand
Not only is increased supply putting pressure on natural gas prices, but a slowing economy and recent near-record natural gas prices have taken a bite out of demand. In fact, Driscoll says demand has dropped by about 6 billion cubic feet per day as natural gas users have switched to alternative fuel sources or simply reduced their consumption of gas.
Although many analysts have argued that the reduction in demand will be more than offset by increased demand this summer for natural gas as new gas-fired power plants come online, Driscoll says new power generation alone won't make up for recent demand loss. "Electric generation demand for gas will not fill the entire demand gap," he notes, suggesting more efficient plants will mitigate part of the impact. "We also expect that more efficient units will displace some inefficient gas-fired units."
In short, Driscoll opines, don't count on new generation to solve slackening demand. "The estimated 1-2 bcfd increase in gas-fired power demand expected this summer is not likely to be enough to offset reduced demand from other customers."
And the demand won't return until the price drops. "We speculate that natural gas prices may need to fall low enough to cause consumers that are currently burning residual fuel oil to switch back to natural gas," Driscoll noted. "As of May 21, low-sulfur residual fuel oil prices delivered to the Northeast were $4.18 per million British Thermal Units. If delivered natural gas prices were to compete with this price it would imply a 'floor' price of about $3.75-$3.80."
No Spark for E&P Stocks
If Driscoll is correct, that could present a challenge for E&P stocks. While his natural gas price estimates -- an average of $5 this year and $4 next -- are still higher than last spring's $3 price, the chance for additional downward revisions of those estimates has increased. In fact, there are now market whispers that suggest gas prices may well drop below the psychologically important $4 mark if storage continues to grow at such a rapid pace.
Combine lower gas prices with the recent strength in E&P stocks, and the chance for a correction in many of those names increases. "Although earnings are likely to remain impressive, and we expect more M&A activity, we think E&P shares are likely to fall in the months ahead."
Driscoll isn't the only one expressing caution. Credit Suisse First Boston exploration and production analyst Phillip Pace thinks current valuations are a bit extended. "While we remain constructive on the industry because of the attractive valuations, there is now clearly risk associated with the reward potential, whereas all we could envision six weeks ago was upside." He added that E&P stocks "are likely to prove lethargic near term."
As an example, Pace downgraded EOG Resources (EOG:NYSE - news - boards) to "buy" from "strong buy" Wednesday morning based on "strong price performance and our concerns over the environment." Other E&P companies that could feel the impact of overly exuberant gas-price forecasts include Anadarko (APC:NYSE - news - boards), Apache (APA:NYSE - news - boards) and Burlington Resources (BR:NYSE - news - boards).
Pace is cautiously optimistic. "We believe the natural gas outlook remains positive despite well-placed fears about temporarily declining demand and rising service costs."
It depends on what your definition of "temporarily" is.
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