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Natural Gas: The Ultimate Bear’s Lair

The worst-performing commodity of 2011?

If you said “natural gas,” you’re spot-on.

The price slumped by 32% last year, as the industry continues to suffer from an enormous supply glut and a continued spike in onshore U.S. production.

And as 2012 gets underway, it’s more of the same.

Following a 5.7% drop on Wednesday, natural gas prices dipped a further 3% today. Over the past week alone, the price has sunk by 13%, and at $2.69 per million BTUs (British Thermal Units), it now sits at its lowest level in two years.

The current mild winter isn’t helping, either. At a time when much of the United States is usually in a deep freeze and the heat is cranked way up, natural gas prices haven’t been this low at this time of year since February 2002.

Of course, in a world where the cost of living is rising and purchasing power is eroding, that’s great news for more than half of Americans who use natural gas to heat their homes.

According to The Wall Street Journal, natural gas customers will pay 18% less this winter. Not to mention lower costs for natural gas-powered businesses and factories.

But it’s a different story for natural gas companies and investors…

Supplies Way Up… Prices Way Down

It’s no secret that the United States boasts a massive excess of natural gas supplies. A record 1.6 trillion cubic feet, to be exact. That’s 13% higher than this time last year and 17% above the five-year average, according to the Energy Information Administration.

So with prices plummeting, you’d think that natural gas companies would ease off the production throttle a bit.

No chance.

Following a 10% rise for onshore U.S. gas production in 2011, Barclays Capital says we’ll see a further 4% climb this year. That’s led Morgan Stanley (NYSE: MS) to forecast an inventory of two trillion cubic feet as soon as March, with a whopping 4.1 trillion cubic feet projected for October. That could smash the price of natural gas below the $2 per million BTU level.

It’s to the point now where some companies are forced to burn off the gas they produce, either because existing pipelines have reached capacity, or because they can’t transport the gas.

So why are companies continuing to produce more natural gas, even as the price plummets?

Fundamentals Be Damned… We’re Drilling Anyway

It’s not that natural gas companies are blatantly ignoring the laws of supply and demand. There are a few reasons why natural gas production continues to rise…

  • As oil production goes, so does natural gas. Many oil fields also contain natural gas, which is often a by-product of oil production. And for energy companies that produce both oil and natural gas, the high price of oil offsets the unprofitable price of gas.
  • Exploration and drilling methods have advanced. Fracking, for example – which involves pumping water and chemicals into rock formations to extract natural gas – has become increasingly popular over the past few years. However, opponents contend that it’s dangerous and can poison water supplies.
  • Natural gas companies must uphold production quotas and land-lease agreements while they own them. In many cases, energy companies will actually lose their lease if they don’t drill on the land.
  • The Wall Street Journal states that because companies are raking in profits from other substances and liquids that come from natural gas, they’re continuing to drill.

Tune Out the Wall Street Bull(ishness)

In addition to an unseasonably mild winter, natural gas companies are adding to an already existing supply glut, so don’t expect the price to rebound any time soon.

As Forbes quotes TD Securities, “U.S. domestic production gains continue to defy fundamentals, as demand hasn’t increased its call on supply to absorb the production gains.”

So it’s perhaps strange to see some very optimistic-looking price projections from some of Wall Street’s big names. Quoted in Forbes, for example…

  • Goldman Sachs (NYSE: GS) estimates an average price of $3.70 this year.
  • Morgan Stanley forecasts an average of $3.85.
  • TD Securities sees an average price of $4.
  • The most bullish forecast comes from Barclays Capital, which predicts $4.10 during the first quarter of the year and $3.60 in the April to June period.

My forecast? Not even close!

Best regards,

Martin Denholm

P.S. While natural gas may be the most hated commodity in the world right now, that doesn’t mean investment opportunities are non-existent. And White Cap Report subscribers know it. In the just-released January issue, my colleague and Wall Street Daily’s Chief Investment Strategist, Louis Basenese, highlighted a great way to take advantage of the natural gas industry’s rapid production.

Martin Denholm

, Managing Editor

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