WASHINGTON -- The natural gas story continues to worsen.

Just when the summer cooling season should begin to have a meaningful impact on natural gas demand, gas inventories continue to build. The

American Gas Association

reported late Thursday that natural gas inventories grew by 105 billion cubic feet for the week ended June 29. That's 39% above the five-year average of 76 billion cubic feet and 11% above the consensus estimate of 95 billion cubic feet.

At 1,822 billion cubic feet, or 55% of capacity, domestic storage is now 124 billion cubic feet higher than it was a year ago. Total additions to storage since March 30 equal 1,195 billion cubic feet; that's nearly double the 605 billion cubic feet injected during the same period last year.

While those data alone don't bode well for natural gas prices or for companies whose profits are tied to natural gas, a deeper look suggests the above-average storage casts even greater doubt on demand for natural gas.

"The above-normal injection level for the week occurred despite weather that was 3% warmer than normal, which should have increased the cooling load and increased demand, all else being equal,"

Banc of America Securities

energy analyst Mark Fischer told clients in a note late Thursday. "We view the storage data as bearish."

That's how the commodities market reacted. The August natural gas contract on the

New York Mercantile Exchange

traded as low as $3.04 per million British Thermal Units, before closing at $3.14, down 7 cents on the day. The 12-month strip, a composite of futures contracts over the next year, finished at $3.62, down from the month-ago $4.01 and the year-ago $3.80.

The report, which was released less than an hour before Thursday's close, didn't seem to have much impact on the rally in energy stocks. The

American Stock Exchange Natural Gas Index

closed up nearly 2.3% for the day, just below its session highs. However, the news may well put pressure on natural-gas-related stocks Friday.

Do Natural Gas Stocks Still Have Gas?

While this report could spook the natural gas markets, cooling-driven demand could still result in a noticeable decline in storage this summer. However, signs of increased demand need to be seen soon to offset what appears to be burgeoning supply if the natural gas market is to sustain a price above the psychologically important $3 per million British Thermal Units level.

If that doesn't happen, the drop in demand -- resulting from a slowing economy and fuel switching when gas prices were much higher this past winter -- could keep prices at or below levels currently used to project natural gas company earnings.

"Should we inject 100 Bcf

billion cubic feet each week over the remainder of the summer, we will end the injection season at over 3.1 Tcf, a level the market would likely interpret as bearish," noted

Merrill Lynch

natural gas analyst John Herrlin. "The dearth of fuel switching and the market's calculation of ending inventories may keep natural gas in the $2.50 to $3.75 range without weather stimuli."

Clearly, companies like

Apache

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,

EOG Resources

(EOG) - Get EOG Resources, Inc. (EOG) Report

and

Mitchell Energy and Development

(MND)

would all feel the impact of sub-$3 gas prices over a prolonged period.

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However, Herrlin thinks there's a good chance that natural gas prices will stabilize. If they do at or near the current 12-month strip price, then the stocks of natural gas producers remain cheap. "At a $3.50 price assumption for the remainder of 2001 and for 2002, the stocks trade at 3 to 5 times

estimated discretionary cash flow per share and still look inexpensive."

That may explain why natural gas stocks didn't react as negatively to Thursday's report as some might expect. In fact, one credible theory suggests the stocks have reached a point where the bad storage news is no longer a surprise. If the stocks hold their own Friday, that strong technical action could suggest at least a short-term trading opportunity in the natural gas and some of the energy service names.

However, as suggested in the past -- most recently on

Tuesday -- timing is everything, and the key will be to watch storage.

"We continue to be cautious on the E&P stocks near term, awaiting lower valuations and/or a reversal in the relative storage build trend to become more positive," concluded Banc of America's Fischer.

Indeed, natural gas investors continue to wait.

Impasse at the FERC

Attempts to bring California and independent power generators to the table to settle on refunds for past power sales in the Golden State have gone nowhere.

The

Federal Energy Regulatory Commission

ordered the parties to the settlement table to develop a proposal to refund some profits from the sale of power at skyrocketing prices since last October. California -- which, under its failed deregulation scheme, forced utilities to buy power on the expensive spot market -- says it is owed nearly $9 billion by out-of-state generators that "gouged" and "pirated" the state to line their pockets with profits.

Power generators, such as

Dynegy

(DYN)

,

Duke Power

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,

Mirant

(MIR)

,

Reliant

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and

Williams

(WMB) - Get Williams Companies, Inc. Report

, say they were simply following the deregulation plan and owe the state nothing. Moreover, the utilities and the state still owe nearly that much to generators and other power marketers for power they provided.

FERC's Chief Administrative Law Judge Curtis Wagner Jr. has spent the past two weeks trying to broker an agreement between the state and the generators before FERC's July 9 deadline. If a settlement is not reached by then, FERC has ordered Wagner to forward recommendations to the commission for action.

While the generators have offered a number of proposals to California for consideration, the state refuses to budge from its $9 billion demand. While even Wagner has suggested the state's number is inflated, the state remains obstinate.

As a result, Wagner is likely to present his preliminary findings to the parties Friday and has scheduled a hearing Monday for the state and the generators to respond. Absent an unexpected settlement, his findings will be submitted to the FERC for action.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, Edmonds' firm was long Mirant, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

Chris Edmonds.