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Crude oil hogs the headlines, so it seems almost natural to pay close attention to that market. And there are certainly some big gains to be made in oil-levered stocks in coming months.

But natural gas and related stocks offer the best near-term opportunity right now.

In the most recent issue of my energy-focused newsletter The Energy Strategist, I included a rally in natural gas into the first half of 2010 as one of my top three investing themes. No commodity has frustrated investors more than natural gas in 2009, and there are still plenty of bears in this market; as these investors gradually recognize the growing list of fundamental changes underway, it will make for some truly explosive gains in the sector. And this is no wild-eyed projection; natural gas stocks have been outperforming crude-levered equities in recent sessions.

Although natural gas prices recently hit a seven-year low on the spot market, the action in longer-dated futures and gas-related stocks suggests that a marked improvement is around the corner.

Looking ahead to 2010, there are some big catalysts for gas--namely, a recovery in demand and rapidly declining supplies. And there’s another wildcard on the horizon: the growing likelihood that any climate change legislation that is proposed in the Senate will include significant carrots for the natural gas industry.

Paradigm Shift

The outlook for US natural gas production and the need to import gas has changed dramatically over the past few years. Paging through back issues of the Energy Information Administration’s (NYSEMKT:EIA) Annual Energy Outlook, I came upon the following chart (click to enlarge) from the 2005 edition.

Source: Energy Information Administration

This graph breaks down net US gas imports by source. As you can see, the US primarily imported natural gas from Canada.

Back in 2005, the EIA projected that US gas imports from Canada would gradually decline over time but remain significant through the entire forecast period. There are a few reasons for this expectation.

For one, the agency assumed that Canadian gas production was nearing a peak. At the same time, Canadian domestic demand for natural gas was on the rise for a number of reasons; for example, producing the nation’s vast oil sands reserves requires large amounts of natural gas. Higher domestic demand and falling, or at best flat, supply translates into less natural gas available for export to Canada’s gas-hungry southern neighbor.

To replace those Canadian gas exports, the EIA expected the US to ramp up imports of liquefied natural gas (LNG), a super-cooled version of natural gas that’s easy to transport.

When gas is cooled to around minus 260 degrees Fahrenheit (minus 162 degrees Celsius), it condenses into a liquid. Better still, as gas cools, it takes up less space; LNG takes up roughly 0.0610 the volume of gas in its natural gaseous state.

To put that into context, a beach ball-sized volume of gas shrinks to the size of a standard ping-pong ball when it’s converted to LNG.

Pipelines traditionally have transmitted the vast majority of natural gas. By extension, reserves located far from existing pipeline infrastructure had little or no value. Oil from such fields can be loaded onto tankers and shipped worldwide, but stranded gas was routinely burned (flared) or re-injected into the ground for permanent storage.

LNG frees gas from geographic constraints imposed by the pipeline grid. In its liquid state, natural gas can be loaded onto tankers and transported anywhere in the world. Thanks to LNG technologies, gas reserves once deemed useless could now be exploited.

Many analysts expected imported LNG to meet rising US gas demand; companies built a large number of import facilities (regasification terminals) to handle the anticipated inflow. As a consequence of greater reliance on LNG, the US would have found itself competing for gas supply with fast-growing Asian countries and the heavily gas-dependent European Union (EU). That likely would have translated into higher prices, just as an increased reliance in imports led to higher oil prices in the 1970s.

But the above-noted projection concerning LNG imports fell short of the mark. In 2005, the EIA projected that US LNG imports would top 1.75 trillion cubic feet in 2008; in reality, the US imported a paltry 352 billion cubic feet (bcf)--less than half the 770 bcf the country imported in 2007.

The US imports some LNG, mainly because most other countries that consume the gas have insufficient storage capacity to handle large quantities of LNG. In the summer months, when heating demand is low, some LNG also finds its way to the US market because there's simply nowhere else to store it. But domestic supply and demand don’t dictate that the US import natural gas; domestic production could be more than sufficient to make the country energy independent, at least when it comes to natural gas.

But the emergence of nonconventional gas plays in the US scuttled the predicted boom in LNG imports. To emphasize the scope and importance of US shale plays, consider the uptrend in the US horizontal rig count (click to enlarge).

Source: Bloomberg

The big growth in US natural gas production is coming from so-called unconventional gas fields. Broadly speaking, the term unconventional--or non-conventional--refers to any field that can’t be produced economically using traditional well technologies.

Unconventional gas production already makes up close to 40 percent of US gas output. And that number is only going to rise in the coming years.

Suffice it to say that two techniques have totally revolutionized unconventional field production: horizontal drilling and fracturing. By drilling horizontally through unconventional rock formations, producers can expose more of their well to productive zones.

And increasingly effective fracturing techniques allow producers to vastly improve the permeability of unconventional fields. This is a fancy way of saying that fracturing makes it easier for gas in a reservoir to flow into a well. Most of my favorite plays on natural gas are either directly or indirectly related to unconventional reserves in the US.

Clearly, horizontal drilling activity has expanded rapidly. In 2003 there were fewer than 100 rigs drilling horizontal wells in the US. But as activity in unconventional plays picked up the rig count jumped to roughly 650 rigs in late 2008. The rig count rose especially quickly from late 2007 through the summer of last year, thanks to higher gas prices.

Even some of the big gas producers were surprised at how quickly US natural gas production ramped up in early 2008. Average daily production in the first six months of the year was up 9 percent from the first half of 2007. And only a lack of rigs prevented production from heading even higher; given the number of unconventional plays, natural gas companies have a surfeit of high-quality reserves to drill.

The horizontal rig count topped out in late-October to early-November of last year as producers reacted to falling commodity prices and the capital constraints imposed by the ongoing credit crunch. But because of a backlog of drilled wells that weren’t yet hooked up to the US pipeline network, US gas production continued to rise, reaching a new high in February of this year.

US natural gas production is now on the decline; the impact of plummeting production activity is finally manifesting itself. I expect this trend to continue through the end of the year, though US gas production data is often volatile from month to month and remains subject to substantial revisions. The latest production data were released by the EIA on Tuesday and are depicted in the chart below (click to enlarge).

Source: Energy Information Administration

The latest data shows production statistics for the month of July; my chart shows the month-over-month change in total US natural gas production. It’s clear the production declines are accelerating.

Some unconventional gas shale plays such as the Haynesville Shale in Louisiana are still economical at current natural gas prices; in fact, Louisiana gas production actually rose in July thanks to continued drilling activity in Haynesville.

However, other plays, such as the Barnett Shale in Texas, aren’t economical. Barnett production is likely already falling sharply and Texas also produces a large amount of natural gas from conventional fields that require gas prices above the USD6 to USD7 per million British thermal unit (MMBtu) level to be profitable.

Production in Texas--by far the largest gas-producing state in the union--has plummeted by nearly 2 bcf per day this year. Production fell 1.2 percent in July compared to June levels.

And while some forecast a big surge in LNG imports this summer thanks to the start up of new LNG liquefaction facilities abroad, that just hasn’t materialized. See my chart below for a closer look (click to enlarge).

Source: Energy Information Administration

Although LNG imports were up compared to depressed levels in July 2008, imports for the month were still around 50 percent lower than in July 2007.

And my chart shows imports from January through July for the years 2007, 2008 and so far in 2009. As you can see, we’ve seen a mild rebound in LNG imports this year, but it’s hardly the flood of LNG most bears were expecting.

Moreover, any gain in LNG imports has been offset by a big drop in pipeline imports from Canada; Canadian drilling activity has fallen even more sharply than in the US.

In late 2008 and early 2009 US natural gas in storage began to build at a faster-than-normal pace, and prices plummeted. The market was hit with a perfect storm: a sharp drop in demand caused by the recession and financial crisis coupled with a production boom from unconventional plays.

This year, the opposite storm is brewing. Natural gas consumption is on the rise as US demand revives and low prices incentivize electricity producers to switch from coal to natural gas fired power.

Meanwhile, US natural gas production is plummeting due to the lack of drilling activity; producers need to see prices rally back over USD6 per MMBtu to start drilling and stem these production declines.

As demand revives into early 2010, gas prices will soar in an exact mirror image scenario to what we witnessed a year ago. Longer term, the US will recognize the power of its unconventional resources; the massive shale plays could easily allow the US to overtake Russia as the world’s largest gas producer.

Natural gas could, at highly attractive prices, displace the need for America to import oil from abroad. The prices needed to make this happen are closer to USD6 to USD7 than the current price.


Source: Natural Gas Currently Offers the Best Near-Term Investment Opportunity