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The purpose of this article is explain why, absent extraordinary weather conditions, U.S. natural gas prices have bottomed and will likely rebound sharply this year.

It's All About Supply and Demand, and Gas Rig Counts Determine Gas Supply

Natural gas supply in the United States is determined primarily by the domestic natural gas rig count. The following chart shows domestic rig counts for the last several years:

Click to enlarge.

As can be seen in the chart, for a number of years the domestic natural gas rig count far exceeded 1000 rigs. Shale gas wells with high initial productivities have led to a significant increase in natural gas production, and have reduced the number of gas rigs needed to counteract natural declines.

To estimate the number of gas rigs currently needed to meet demand in a stable price environment, I will focus on rig counts in 2010 and 2011, which was a time of relative price and supply stability with gas wells similar to those today. In 2010 and 2011, gas rig counts averaged around 900 rigs in the U.S. Although high shale gas well initial productivities led to a slightly oversupplied condition in this time frame, it was not a dramatically oversupplied condition.

Then, of course, came the exceptionally mild 2011/12 winter. Natural gas in storage had recently swelled to 56% above normal conditions, and fear has taken hold that natural gas storage will reach maximum capacity before the 2012/13 winter, which would cause a further collapse in prices. Natural gas prices fell below $2 per mcf last month, which is far below the cost of production for almost all dry gas plays.

Various natural gas exploration and production companies responded by announcing drilling cuts. Natural gas rig counts have steadily dropped since late last year, falling to the low 700s in February, high 600s in March, low 600s in April, and have now recently fallen below 600 in early May. This represents approximately a one-third drop in new gas wells coming online. My conclusion is that the current gas rig count is insufficient to counteract natural gas well production declines (which are steep for shale gas wells in the first two years of production), and will cause an accelerating decline in natural gas production until natural gas rig counts increase.

Associated Gas Production from Oil Wells Only Partially Offsets the Decline

I note that various commentators have argued that the decrease in natural gas rig counts won't reduce natural gas production because of the offsetting increase in associated gas from the growing number of oil wells and liquid-rich gas plays. While this is an offsetting factor, the increase in associated gas production from oil and liquid plays does not nearly make up for the large decline in natural gas drilling. A back-of-the-envelope calculation follows.

As a starting point, I note that from the time of relative gas supply and demand stability, the gas rig count has since dropped by about 300 rigs, while the oil rig count has climbed by 300-500 rigs (depending on the time chosen). As a rough calculation, associated gas production from each additional oil and liquids rig is estimated at 25% of the gas production from a gas rig.

While there are some liquids plays that produce a higher percentage of associated gas (e.g., Mississippi Lime and Eagle Ford plays produce a higher percentage of associated gas), there are also many plays that produce a much lower percentage of associated gas (e.g., the Bakken, where only about 5% is gas, much of which is wasted by flaring) and/or which are less productive than the pure gas plays (i.e., mediocre liquids plays sometimes replace very productive gas plays). Therefore, I estimate that the increase in associated gas production from the 300-500 rig increase in liquids drilling is the equivalent of only 75-125 gas rigs, and thus offsets only a minor portion of the 300 gas rig decline.

Likewise, while some may argue that increased drilling efficiencies and improved drilling practices increase the number of wells and well productivities achieved with each gas rig, that would also offset only some of the large rig decline. Again, I am comparing only against 2010 and 2011, not against several years ago when shale plays were in their early stages and gas rig counts were much higher still.

Efficiencies have improved some over these last two years. But even if the 600 current gas rigs now can produce as much new gas as 700 rigs could just one year ago, that would still not be enough to offset the gas rig decline. And I expect gas rig counts to continue to fall through June, to around 550 gas rigs, given several recent announcements of further reductions in rigs scheduled to take effect this year.

In short, as long as the gas rig count in the U.S. is below about 700 rigs, and particularly below 650 rigs, I am bullish on natural gas prices in the U.S.

The Demand Side: Natural Gas Market Share in Energy Consumption is Rising

As detailed in a series of recent articles for Seeking Alpha by Paulo Santos, natural gas' market share in its primary market has risen significantly since November 2011 due to coal-gas switching in the utilities sector. This switching has been largely obscured so far due to the extremely mild winter weather which prevented apples-to-apples comparisons with prior years, along with the delays in receiving critical production and consumption data. Nevertheless, it is becoming clearer that the demand side of natural gas also bolsters the bull case for natural gas, absent more extraordinarily mild weather.

What About the Large Amount of Gas in Storage?

While there is a large surplus of gas in storage, the percentage above normal surplus levels has been shrinking now for several weeks. Once 56% above normal storage levels a couple of months ago, the surplus above last year's level is now 44% and falling. In addition, for the last few weeks, injections of natural gas into storage have been about one-half normal injection levels for this time of year.

Given the very low gas rig count, these injection levels will continue to drop, accelerating for the near future as long as the gas rig count continues to be so low. I suspect that within a couple of months it will be clear that maximum storage capacities will not be reached this year, and that the supply of new natural gas being created by the current rig count will not be sufficient to match consumption without continuing to eat into storage for the foreseeable future. When that happens, the prevalent fear of collapse in natural gas prices will recede, and appreciation in future gas prices will be rapid.

If Natural Gas Prices Rise, Won't Any Upside be Short-Lived and Limited by a Gas Rig Count Rise or by Utilities Switching Back to Coal?

As seen in the chart at the beginning of this article, the total rig count in the U.S. right now is over 1900 rigs, already near an all-time high. In other words, rig utilization in the oil services sector is near capacity, largely tied up by profitable oil drilling. Many oil and gas exploration companies are also already short on capital and short on skilled manpower. As a result, any regrowth in gas rig counts will be constrained. Rapid substantial increases in the gas rig count, large enough to significantly increase gas supply, will require moving some rigs back to gas plays from liquids plays, at least in the near term.

Because of the much-higher profitability of the oil and liquids plays, this would not happen in large numbers without a very significant rise in gas prices (e.g., to perhaps $5 per mcf, at which point some highly productive gas plays are more profitable than liquids plays). Such a rise in gas prices could also cause some switching back to coal, but such switching back would also probably not occur while gas prices are less than $3.50 per mcf. So I see near-term upside in natural gas at least to that level.

The Best Way to Invest in Natural Gas Right Now

One way to invest in natural gas right now is through natural gas exploration and production companies, particularly those whose shares have been beaten down by fears of exceptionally low natural gas prices. One example would be Chesapeake Energy (NYSE:CHK), which has particularly large gas assets and is particularly susceptible to financial harm from low natural gas prices given its current financial condition. A significant and sustainable rise in natural gas prices would dramatically benefit a company like CHK. At the time of writing, CHK is below $15, which represents an outstanding entry point for this equity.

Another way to invest in natural gas prices is through the United States Natural Gas Fund (NYSEARCA:UNG). The UNG is designed to track natural gas prices. While the UNG suffers costs from contango and from administrative costs which make it a poor long-term investment, it would be a good investment choice to capture rapid short-term upside movements in natural gas prices, which is what I expect will occur in natural gas prices over the next several months.

As gains in commodity prices do not always translate to the commodity producers, at least not proportionally (I experienced this the hard way in 2009, as I correctly anticipated the rapid increases in oil prices that year but failed to reap much reward through ownership of stock in oil producers), my preference for a short-term investment is the UNG, with CHK as a preferred long-term choice.

Many other natural gas and coal stocks will benefit from price appreciation in natural gas, so the number of potential investment strategies are legion.

Disclosure: I am long CHK, UNG.