Natural Gas: If It Walks Like a Duck . . . Natural gas fundamentals are clearly the worst in recent
memory. Strong onshore production growth came at the worst possible time, as the recession and credit
crunch caused tremendous demand destruction, pushing prices below $5 per Mcf. However, a declining rig
count, combined with steep initial production declines from unconventional natural gas wells, has us
optimistic that by 2010, production levels could be more in balance with market demand and therefore
support higher average natural gas prices. Certainly, an economic recovery that spurs more industrial
demand would help, as well as higher weather-related demand. Until then, an over-supplied market with a
widening differential between current storage and the five-year average, in addition to poor year-over-year
comparisons, could continue to pressure the market and natural gas-weighted E&P equities.
Crude Oil: How Low Can it Go? . . . Crude oil fundamentals aren’t much better. Until we begin to see
indications of OPEC production cuts in the weekly inventory data, the glut of inventories at Cushing and an
extreme contango forward curve are likely to continue to pressure front-month WTI prices in the short term.
Longer term, we believe OPEC reductions, combined with the recent decline in commodity prices and the
credit crisis, are likely to reduce future investment in the exploration and production sector, resulting in
project delays or cancellations that could materially affect future supplies. As the world economy begins to
recover in the next few years and beyond, a tighter-than-expected supply/demand balance could emerge
and result in another leg up in crude oil prices. We would not be surprised to see one more OPEC cut given
forecasted consumption in 2009.
Seasonality Revisited . . . Despite atrocious fundamentals, we believe there will be seasonal trading
opportunities, at a minimum, in the group. Over the past 14 years (1995-2008), the S&P Supercomposite Oil
and Gas Index has generated an average annual return of 14.7%, with eight of the last ten years positive,
including six consecutive up years. However, 2008 ranks as the worst year since 1998, with the E&P Index
down 38%. While performance has been quite good largely due to rising commodity prices over the past 10
years, there is also a seasonal effect that merits noting. While average monthly returns have been superior
in the months of March and December, the four-month period of February through May has yielded an
average return of 16.5% over the past 14 years. If natural gas and crude oil continue to weaken as the
current commodity contracts roll, we think it could set up a healthy group bounce in late February that could
last into April.
Adjusting Commodity Prices and Top Picks . . . We are decreasing our commodity estimates for both oil
and gas for 2009 and beyond. We are lowering our 2009 estimates to $5.50 per Mcf and $45.75 per barrel
from $7 per Mcf and $70 per barrel. Further, we are cutting our long-term estimates to $55 oil and $6 natural
gas, where we think the energy equities should trade, from $70 per bbl and $7 per Mcf. We are lowering
our ratings on Continental Resources (CLR) to Accumulate from Buy; Encore Acquisition Corp.
(EAC) and Penn Virginia (PVA) to Neutral from Accumulate; and Brigham Exploration (BEXP) to
Neutral from Buy. We are upgrading Ultra Petroleum (UPL) to Buy from Accumulate. All
adjustments are based on valuations given expected year-end results.
Our top picks in the near term are again focused on the best of the best. Our top picks are XTO
Energy (XTO), Petrohawk Energy (HK), Southwestern Energy (SWN), Ultra Petroleum (UPL), and
Carrizo Oil & Gas (CRZO).