Naturally not Participating

The global commodities boom is something of a wonderment. The fledgling economies of Asia, India, Brazil and Russia continue to feed off of each others prosperity. As these economies grow so does their demand for raw materials such as copper, cement and oil. The result is an incredibly strong demand for resources of the likes, which haven't been seen since the post World War II infrastructure build-out in the United States. Due to this demand, commodities such as gold and oil are nearing multi-decade highs. Inversely, natural gas prices sit at painfully low levels compared to their post Katrina and Rita peaks. This lack of participation beckons me to scout natural gas producers for potential value buys.

These pricing extremes reiterate natural gases' inherent volatility. With natural gas storage at 5-year highs, the rational for price depression becomes transparent. Natural gas prices cannot rally until the supply and demand equation once again becomes skewed. The question is, what could cause natural gas prices to rise?

There are three readily apparent scenarios which could cause natural gas prices to spike: 1)Reduction in output from drillers and producers, 2)Supply shocks for competing commodities and 3)Potential natural gas demand/supply shocks.

Reduction in Supply

Several natural gas producers such as Chesapeake Energy Corp.(CHK) and Questar Corp.(STR) have already announced plans to scale back production as a method of price stabilization. The concern here is that additional production reductions could result in political upheaval. This was seen recently when ill-informed Connecticut Gov. M. Jodi Rell's made accusations that CHK was attempting to manipulate natural gas futures.

CHK's Chairman and CEO Aubrey McClendon succinctly pointed out that, "no US law requires any producer or manufacturer in America to produce a product at a prescribed level, especially if selling such a product could result in the risk of an economic loss." While McClendon is accurate, the likelihood of a significant reduction in natural gas production seems unlikely.


Related Commodity Demand/Supply Shocks

In the United States, the bulk of domestic electricity generation comes from sources such as coal, hydro-electric and nuclear. Since natural gas has a higher relative fuel cost compared to these alternatives, it is often used as the proverbial bench-warmer. During periods of high demand or supply shocks, natural gas based electricity generation is used to recoup differentials brought about by these disruptions. This is primarily due to the intrinsic flexibility of natural gas compared to the alternatives such as coal.

During the 1990s, extensive droughts experienced in the west caused steep declines in hydroelectric generation. As a result, hydroelectric production declined 40% from 1997 to 2001(PDF). This reduction was largely offset by a 30% increase in natural gas generation.

Natural Gas Demand/Supply Shocks

This brings us to my final point. The largest mover of natural gas prices is in fact natural gas demand/supply shocks. During late 2005, Hurricane Katrina and Rita collectively shut down 800 billion cubic feet(Bcf) or natural gas(PDF). To put it into perspective, this is equivalent to nearly 25% of the total annualized natural gas production from the Federal Gulf of Mexico. This supply shock was precisely the reason why natural gas moved from just over $6.00 per million BTU(MMBtu) to $15 (MMBtu).

With September over, the likelihood of a hurricane educed catastrophic occurring this year is rather remote. What could occur however, is a colder than expected winter. While I will refrain from using our friendly, yet remarkably inaccurate weather man as a gage for my speculations, I will point out that natural gas appears fairly undervalued when compared to 5-year trends. This could signify an attractive entry point for such prized natural gas drillers as CHK or XTO Energy(XTO).