Natural Gas Finally Shows Some Spark

The ongoing an energy revolution in the U.S. has generated a glut of natural gas. Over the past year, inventories have piled up as new drilling techniques have producers such as Chesapeake Energy (NYSE:CHK) extracting unprecedented amounts of gas trapped in rocks.

And, of course, that inventory buildup has driven prices for natural gas down to historic lows. At one point, natural gas futures slipped below $2 per million British thermal units (Btu) — a level not seen since January 2002. That spurred many some producers to curtail production and switch to more profitable natural gas liquids (NGL) and shale oil.

Now, these efforts to reduce production and idle wells may finally be bearing fruit: Natural gas prices have surged over the last few months as higher demand coupled with lower supplies have begun to work their way through the system.

The tide may have turned for the natural gas producers, and for investors, now could be the time to buy.

Hot Weather and  Lower Supplies

The recent heat waves may have crops withering across the heartland, but they’ve also helped push natural gas prices up more than 70% over the last few months. Those blistering summer temperatures have air conditioners and fans working overtime, requiring power generators to burn more natural gas to meet demand.

Futures for the fuel located at the Louisiana storage facility and pipeline terminal known as the Henry Hub have surged to a new seven-month high. Natural gas has gone from a decade low of $1.85 per million Btus in April to over $3.14 this past week.

Natural gas is seen a preferred fuel for power generators because it can be turned on and off relatively quickly during times of peak demand. This, combined with the fact that more utilities are switching to the cleaner fuel, has helped push inventories lower and lower. The total in storage now is only 17.5% above the five-year average for this time of year. That’s down significantly from  March, when inventories were 60% above average.

Still, production remains low. Firms like Devon (NYSE:DVN) began to switch to more rewarding shale oil and NGL. In April, roughly half of the 1,800 drilling rigs in the U.S. were looking for oil, while half were looking for gas. Data from Baker Hughes (NYSE:BHI) last week showed the gas-directed rigs fell to a 13-year low of 518. It was the eighth drop in the past nine weeks. More recently, the Energy Information Agency has reported natural gas production numbers are slightly below levels seen at the end of 2011.

Lower production, rising demand and falling inventories are certainly bullish for natural gas prices and producers.

Who Stands to Benefit?

While some analysts have cautioned that the current rally in prices could reverse course, the rest of summer 2012 looks to stay hot. Prices should rise or at least hover at these levels for some time.

The easiest way to gain access to the sector is through the First Trust ISE-Revere Natural Gas Index ETF (NYSE:FCG). The fund tracks 31 firms that derive a substantial portion of their revenues from the exploration and production of natural gas. This includes heavy hitters like Noble Energy (NYSE:NBL) and EOG Resources (NYSE:EOG).

So far, the fund has performed poorly in the face of lower gas prices. However, the continued heat wave and the price reversal will benefit the index’s underlying stocks. The fund charges 0.60% in expenses and offers a great broad bet on the sector’s return to glory, even if only relatively.

Perhaps some of the biggest beneficiaries will be those “pure” natural gas players like Quicksilver Resources (NYSE:KWK). Another to consider is Cabot Oil & Gas’s (NYSE:COG), whose recent earnings miss highlights how dependent it is on the fuel. Cabot reported weak second-quarter 2012 results of just 5 cents a share due to lower gas prices.  This compares to 20 cents EPS last year when prices were much higher. Needless to say, higher prices for natural gas will pad Cabot’s bottom line and the stock’s drop after the recent earnings miss provides a great entry point.

Overall, rising prices could be a sign that the sector has finally turned a corner.

As of this writing, Aaron Levitt doesn’t own any securities mentioned here.

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