Natural Gas Market Falling Victim to the Bear

Market commentators believe that the current market situation is a reaction to diminished demand for fuel due to a warm winter, and a supply glut created by large-scale discoveries.

As the commodity’s price continues to plunge, many are claiming that it is difficult to find even a single area where it is profitable to drill for natural gas alone within the North American region, with most companies now opting to drill for oil and ethane, producing gas as a by-product. The dire scenario has meant that exploration and drill counts have reacted accordingly.

In a recent analysis report, Houston-based oilfield services company Baker Hughes Inc. (NYSE:BHI) reported a dip in US rig count numbers. The company stated that the drop can be attributed to a decrease in the tally of both oil- and natural gas-directed rigs, which as of the end of March recorded a new ten-year low.

The report noted that the natural gas rig count decreased to 652 on the week ended March 23. Even more alarmingly from an exploration and production perspective, the number of gas-directed rigs is at its lowest level since May 2002, and is 59 percent below the all-time high it reached in late summer 2008.

Zacks Investment Research has added to this bleak outlook by stating that with horizontal rig count – the technology responsible for abundant gas drilling in domestic shale basins – close to a record high, the “grossly oversupplied” market will continue to pressure commodity prices in the backdrop of sustained strong production.

It seems that players within the natural gas sector are also adopting a bearish outlook, with several exploration and production outfits, including Ultra Petroleum Corp. (NYSE:UPL), Talisman Energy Inc. (TSE:TLM), and Encana Corp. (NYSE:ECA), reducing their 2012 capital budget to minimize investments in natural gas development drilling.

Chesapeake Energy optimistic

Despite this negativity, a number of producers have taken a more bullish outlook, with Chesapeake Energy Corp. (NYSE:CHK) opting to shut in production to cope with the current weak environment for natural gas. The second-largest US natural gas producer has argued that there are good reasons to be bullish in the medium and long term due to shrinking supply and growing demand from the power, transportation, industrial, and export sectors.

In a recent presentation, the company argued that the NYMEX forward price curve for natural gas is failing to recognize future supply and demand fundamentals, and is likely “one of the most mispriced investments in the market.”

It forecasts that power companies will increase natural gas demand by ten to 15 billion cubic feet a day over the next decade, that surging gasoline prices will force policy changes to stimulate the market for compressed natural gas (CNG) and liquefied natural gas (LNG)-powered vehicles, and that the US and Canada will be exporting LNG by the end of 2015.

In a recent interview, Jim Nieuwenburg, a partner with Calgary-based private equity group KERN Partners, said it is difficult to determine “whether it’s good to go into gas now or later.”

“For new entrants or for incumbents who are looking to expand their position, it probably is a good time, if you’ve got a long-term perspective,” Nieuwenburg said. “I would say the current situation of gas pricing is not sustainable.”

Some investors remain bullish

Interestingly, despite the market outlook and depressed market price, it is not only producers that are displaying a bullish sentiment.

A select few investors have decided they “are crazy enough to invest in it,” said Ken Woolner, CEO of Velvet Energy Ltd., a private company that bought $209 million in natural gas assets earlier this year.

In an interview with The Globe and Mail, Woolner suggested that his willingness to invest in the market has nothing to do with analysis, but rather history, stating that natural gas has entered a “more bearish than just bearish, depressing, it-can’t-get-any-worse phase.”

According to Lou Pugliaresi, President of the Energy Policy Research Foundation, although natural gas prices are forecast to rise in the long term, from an investor’s standpoint the increase is unlikely to occur swiftly or be very large as some sources of higher demand will take time.

“Is it likely that the price will move off $2?” he asked. “Yes. But the road back to $5 or $6 is going to take a while.”

Positive sentiment was once again dealt a blow with last week’s release of the US Energy Information Administration‘s (EIA) Weekly Natural Gas Storage Report.

According to the report, working natural gas in storage as of March 30 totalled 2,479 billion cubic feet (Bcf) – 816 Bcf greater than the five-year maximum for that date. Inventories for each week ending in March have been greater than 2,300 Bcf; the next highest March inventory level of any year for the 18 years for which the EIA has data is 1,887 Bcf, recorded for the week ending March 3, 2006.

Takeaway for investors

From an investor’s standpoint, with swelling US natural gas inventories, plunging futures prices, and weather that has recently seen little need for gas as a heating fuel, it is proving difficult to forecast that the market will see any significant rebound in the short to medium term.

With natural gas unlikely to witness a durable rebound in prices, and with crude prices currently topping $100 a barrel, producers are likely to be boosting liquids exploration in order to take advantage of this trend. As a result, movement of rigs away from natural gas towards oil is the likely reality in the short term.

Securities Disclosure: I, Adam Currie, hold no direct investment interest in any company mentioned in this article.