There are two recent fundamental developments that can cause the price of natural gas to rise significantly in the near-term from the current price of around $2.39 per MMBtu. The most important of these is the large amount of coal to gas fuel switching by electric utilities and independent power producers that started last November and has continued since then. This behavior is likely to continue until gas prices move much higher, and it means that significantly more gas will be used to make electric power than in the past. The second most important development is the prospect of a further reduction in drilling, which is already at a relatively low pace, along with producers increasingly deferring the completion of wells that have already been drilled. This should slow the production growth that has been occurring in recent years.
The amount of working gas in underground storage is a good indicator of the balance between supply and demand in the natural gas market, and it has recently been indicating a huge over-supply of gas. At the end of the heating season on March 30 (the beginning of the refill season) working gas in underground storage was 2,472 Bcf. This compares with a five year (2007 - 2011) average, maximum, and minimum of 1,545 Bcf, 1,663 Bcf, and 1,244 Bcf respectively for the end of the heating season. In other words the inventory was 927 Bcf higher than the average and 809 Bcf higher than the maximum for that time of the year.
The reasons for the much higher than normal inventory at the end of the heating season are well understood in the market. Supply has been increasing and is high primarily because of the rapid growth in the production of shale gas. At the same time in December through March temperatures were much warmer than normal, so demand for gas for residential and commercial use was much lower than normal.
This very high level of inventory at the end of the heating season has led some market participants to expect that storage capacity will be maxed out by the end of the refill season at the end of October. In turn this has put tremendous downward pressure on the price of natural gas. However, since hitting a low of $1.90 per MMBtu on April 19 and April 20, the nearby futures contract has risen to a recent price of around $2.39, which may indicate that perceptions about what is going to happen during the refill season are changing.
I have modeled natural gas production and consumption on a monthly basis for all of 2012, and what this model indicates is that working gas in underground storage will be 3,785 Bcf at the end of October, which is within the normal range for that time of the year. The five year (2007 - 2011) average, maximum, and minimum is 3,685 Bcf, 3,832 Bcf, and 3,429 Bcf respectively for the end of the refill season.
A summary of the model results that relates to working gas in underground storage during the refill season is shown at the end of this article. The essence of what it is showing is that small continued growth in the production of gas is significantly more than offset by higher use in electric power generation, and that this will be reflected in the amount of working gas in underground storage.
Investors can profit from rising natural gas prices by owning natural gas futures or owning the stock of companies that will benefit from the price change. My favorite stock pick is Ultra Petroleum (UPL). The company is a low cost producer, and it is significantly undervalued compared to most other gas E&P companies particularly on an enterprise value to proved reserves basis. Also, since rising gas prices will cause electricity prices to rise, Exelon (NYSE:EXC) will benefit greatly because of its large merchant power business with 55% of its generating capacity being nuclear.
Disclosure: I am long UPL, EXC.
Additional disclosure: I am long natural gas futures.