(LNG) Will Natural Gas Rebound This Year?

Among the most commonly asked questions by energy investors this new year is: will low natural gas prices continue in 2012 or will we see a durable rebound in prices from their multi-year plight?

From a peak of about $13.60 per million British thermal units (MMBtu) in 2008 (referring to spot prices at the Henry Hub, the benchmark supply point in Louisiana) to around $3.00 now – sinking in between to a low of $2.50 in September 2009 – the plummeting value of natural gas represents a decline of over 75% over three years. In fact, prices have been low, roughly around $4.00 per MMBtu, during this timeframe. Thanks to this steep fall, industry participants are pressing the panic button.

But it Hasn’t Always Been this Way…

It wasn’t long ago that the nation was facing a real natural gas supply shortage, which sent prices on a tear. It is almost impossible to imagine that things once looked so miserable on the U.S. natural gas supply front that plans were made to invest money in liquefied natural gas (LNG) import terminals to bring in natural gas from overseas. This commodity shortage meant that natural gas was in a raging bull market in 2005 and in 2008, with prices skyrocketing.

Factors Behind the Decline

But then something happened; the success of ‘shale gas’ – natural gas trapped within dense sedimentary rock formations, or shale formations. This unconventional fuel source transformed domestic energy supply, with a potentially inexpensive and abundant new source of fuel for the world’s largest energy consumer.

With the advent of hydraulic fracturing (or fracking) – a method used to extract natural gas by blasting underground rock formations with a mixture of water, sand and chemicals – shale gas production is now booming in the U.S. Coupled with sophisticated horizontal drilling equipment that can drill and extract gas from shale formations, the new technology is being hailed as a breakthrough in U.S. energy supplies, playing a key role in boosting domestic natural gas reserves.

As a result, once faced with a looming deficit, natural gas is now available in abundance. Through their technical advancements, independent producers like Chesapeake Energy (CHK), EOG Resources Inc. (EOG), Southwestern Energy (SWN) and their ilk were actually so successful in pumping up natural gas volumes that it rocked the price of the product that they were selling.

So while most commodities have at least doubled in price over the last 3–5 years, natural gas prices have not recovered. In fact, they are currently trading at their lowest level in more than two years.

What’s surprising is that even the recent, steady fall in the natural gas rig count has failed to stem the rise in natural gas production.

Defying Rig Count

Every week, Houston-based oilfield services company Baker Hughes Inc. (BHI) releases a rig count, tallying the number of rigs searching for oil and gas in the country. And after analyzing the numbers, we find that the natural gas rig count has been falling since the last few weeks, 125 rigs in fact (or 13%) from its recent high of 934 on October 28.

Now, as per conventional thinking, this (a lower rig count) would indicate that a significant production decline is positively on the horizon. However, this is not as simple a conclusion as it might seem, if we look at the U.S. production and the shift in rig composition.

With horizontal rig count – the technology responsible for the abundant gas drilling in domestic shale basins – close to its record high, output from these fields remains robust. As a result, gas inventories still remain at elevated levels – 13.7% above the 5-year average and 9.1% higher than the same period last year.

Fundamentals Don’t Back a Big Move in 2012

Looking ahead, EIA expects average total production to rise by 2.8% in 2012 (to an all-time high 67.72 billion cubic feet per day, easily eclipsing 2011’s record high estimate of 65.9 billion cubic feet per day), while total natural gas consumption is anticipated to grow by just 1.7% next year. We believe these supply/demand dynamics – the projected lower consumption growth compared to production – will weigh on natural gas prices, translating into limited upside for natural gas-weighted companies and related support plays.

In the absence of major production cuts or a stronger economy to boost industrial demand, which is responsible for almost a third of the gas consumption, we do not expect much upside in gas prices in the near term. In other words, there appears no reason to believe that the supply overhang will subside and natural gas will be out of the dumpster in 2012.

In the past, winter weather has played a factor in boosting prices with demand for domestic natural gas exceeding available supply. But with no dearth of new supply, even this association is becoming more and more obsolete.

Where’s the Opportunity Now?

With the industry average production cost at around $5 per MMBtu and natural gas hovering around the $3.00 range, most of the producers are close to or below their break-even. Even big companies like EnCana Corp. (ECA), Chesapeake, Royal Dutch Shell (RDSA) have seen their share prices erode. As such, we can see why investors are scared to dip their feet into natural gas stocks.

However, some (like Chesapeake) are better equipped than others and this is because of their initiative of deploying more funds toward liquids. One can also opt for large gas producers like ExxonMobil (XOM) and Chevron Corp. (CVX) that have the deep pockets to wade through the rough waters.

Another way to play the market is to look for the lowest producers of natural gas. These include firms like Ultra Petroleum Corp. (UPL) and Southwestern – both with substantially lower production costs. These companies will get the best results when natural gas finally rallies and be the ones who will stay afloat the longest if prices stay low.

BAKER-HUGHES (BHI): Free Stock Analysis Report

CHESAPEAKE ENGY (CHK): Free Stock Analysis Report

CHEVRON CORP (CVX): Free Stock Analysis Report

ENCANA CORP (ECA): Free Stock Analysis Report

EOG RES INC (EOG): Free Stock Analysis Report

ROYAL DTCH SH-A (RDSA): Free Stock Analysis Report

SOUTHWESTRN ENE (SWN): Free Stock Analysis Report

ULTRA PETRO CP (UPL): Free Stock Analysis Report

EXXON MOBIL CRP (XOM): Free Stock Analysis Report

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