One of the hottest summers on record, back-to-back Category Three-plus hurricanes on the Gulf Coast, refinery disruptions and bottlenecks, plus high energy demand, have all combined in recent months to propel oil and gas prices to historic levels. Now, as the winter-heating season approaches, investors have more than a few questions. Will E&P stocks figuratively run out of gas? Just how expensive are they right now? What pricing assumptions are they discounting? Will the U.S. itself quite literally run out of gas in the event of a Katrina-size winter cold snap? Finally, what's the best way today to position an upstream portfolio? Shannon Nome, E&P analyst for JP Morgan Securities in Houston, tackles this tidal wave of issues in an early fall report. She has developed a model that calculates the price deck imbedded within E&P share prices, based upon year-end 2004 SEC PV-10 disclosures rolled forward to estimated year-end 2005 values. "Currently, our 'price discounted' model indicates that E&P stocks are discounting $6.82-per-Mcf (thousand cubic feet) gas over the life of their reserves, or roughly $45-per-barrel oil, on a pre-tax PV-10 basis," Nome says. However, on an after-tax basis, these appear roughly 14% more expensive, discounting closer to $7.80-per-Mcf gas. "This is an important distinction since, in this high commodity-price environment, most producers are paying cash taxes given their significant earnings generation." This said, she points out that the long-dated, gas-futures strips have been recently running at $9.18 to $9.98, "so there is still quite a significant valuation gap between the prices available in the futures market and those imbedded in E&P share valuations." (At press time, the 2006 strip was north of $11.) As to whether the U.S. might literally run out of gas, Nome ran several scenarios to determine whether a cold winter could indeed result in a record drawdown in gas storage levels-recently about 2.89 trillion cubic feet (Tcf)-from November 1 forward. The worse-case scenarios? "If the weather is 15% colder than normal, we could envision a season-ending storage tally as low as 629 billion cubic feet (Bcf)-well below the all-time low of 730 Bcf," the analyst says. Worse still: if there comes a more quickened pace of drawdown per degree day triggered by lingering gas-supply outages in the Gulf of Mexico, then season-ending storage levels could theoretically dip below 500 Bcf. "In light of these scenarios, our feeling is that natural gas prices will remain well supported in double-digit ranges over the upcoming winter months," says Nome. "So while we most assuredly will not run out of gas this winter, we certainly could-and may have already-run out of affordable gas." Given this assessment, the analyst remains bullish on upstream stocks and views any pullbacks in E&P stock prices between now and year-end as buying opportunities. Nome continues to focus on those producers with low cost structures, low asset intensity (which measures maintenance capex as a percent of cash flow), visible drilling inventories and low financial leverage. She thus has Overweight ratings on such gas-weighted stocks as Southwestern Energy, EOG Resources, Range Resources, Ultra Petroleum, Western Gas Resources and XTO Energy. Stephen Smith, Natchez, Mississippi-based president of Stephen Smith Energy Associates and publisher of Monthly Energy Outlook, observes that by early fall U.S. gas-storage surplus levels had dipped to 100 Bcf from 400 Bcf going into the summer. Supply could get tighter. "Due to the longer-than-expected shut-ins from hurricanes Katrina and Rita, it's possible we could see by year-end 2005 storage levels that are 50- to 100 Bcf below historical 10-year norms-which could easily result in Henry Hub prices as high as $12 per million Btu." In such an environment, the analyst is emphasizing among core energy investments large E&P companies that have a diversified onshore gas exposure and that have achieved economies of scale in important gas basins. "We also look for a large drilling inventory, demonstrated technical competence in unconventional gas plays and a seasoned management team 'ahead of the crowd.' On this basis, Chesapeake Energy and XTO Energy rank at the top of our holdings."