Listen Closely: Natural Gas Supplies Are Telling You Something

The natural gas market is telling you something. But what natural gas producers are whispering may be much more important.

With the American Gas Association detailing a third week of near-record injections -- the term used to describe natural gas placed into storage for later use -- prices are under attack.

The 108 billion cubic feet of storage added last week was the highest weekly storage increase in six years. In turn, the price of natural gas has slid nearly 20% in the past three weeks. The June natural gas contract at the New York Mercantile Exchange is quickly approaching the psychologically important $4 per-million British thermal unit (MMBtu) level. The contract closed at $4.20/MMBtu on Wednesday.

Analysts are becoming more bearish on natural gas prices by the day, both on gas prices and the impact lower prices might have on investors' perceptions on exploration and production stocks. Ron Barone of UBS Warburg is considering reducing his current $5.75/MMBtu average price forecast for the year, suggesting it "is growing aggressively and will require adjustment if weakness continues."

The decline in the price of natural gas may begin to weigh on the price of exploration and production companies that have significant gas assets and production profiles. "We view the storage data as bearish and continue to urge caution with regard to E&P stocks," wrote Banc of America Securities energy analyst Mark Fischer after the AGA numbers were released.

Short-Term Pressure, Long-Term Opportunity

There is little chance that natural gas storage injections will slow in the coming weeks. With extended forecasts calling for near-normal spring weather, continued injections aren't threatened by unusual heating or cooling demand.

Increased storage will put additional pressure on commodity prices. "With relatively mild weather expected, we expect several more large injections during the next few weeks, which could put some additional pressure on prices," says Raymond James gas analyst Wayne Andrews. That in turn is likely to put short-term pressure on the stocks of natural gas companies.

But what happens after the shoulder months -- the time between winter and summer when demand for natural gas is lowest -- presents an intriguing opportunity for investors, especially if the production data from E&P companies is a hint of things to come.

The summer of 2001 will be remembered as a time when the characteristics of natural gas demand change forever. With estimates of as much as 40,000 megawatts of new power generation coming online this summer -- with almost all of it fueled by natural gas -- the summer months will become almost as taxing on natural gas supplies as the winter heating months.

"Our numbers show that during peak electric demand periods additional consumption could be 5 to 10 billion cubic-feet per day (Bcf/d) higher this summer than last," says Raymond James director of energy research Marshall Adkins, a member of the TSC Energy Roundtable. "This changes the current market from 5 Bcf/d excess gas to as much as a 5 Bcf/d shortfall in the heat of summer."

That means current storage levels and projections might meet the summer demand for natural gas, but could leave storage dangerously low going into the traditionally strong winter heating months, pushing commodity prices back into range of Barone's estimate.

But wait. The frenzy of increased exploration and production should help offset the demand from power generators at some point this year. After all, the number of rigs drilling for gas has increased by more than 50% since last year, and the rush to bring gas to market must ease the supply crunch.

So far, that hasn't happened. A recent survey by Merrill Lynch analyst John Herrlin shows gas production is barely growing. "[N]atural gas output was up 0.4% from [the first quarter of 2000] and only up 0.9% from [the fourth quarter]," he notes in the survey findings.

And he thinks the anemic trend will continue. Domestic production companies "at best, can collectively grow input by 1%-1.5% with high rates of activity, and that sustained output level requires above historic average rig counts," he notes. "2%-3% production growth forecasts by the Street are simply wrong or won't be sustained on a multiyear basis."

That leads Herrlin to this conclusion: "Gas isn't dead, nor are the E&P stocks."

So how do you play the almost certain resurgence in gas prices? First, Jim Cramer's suggestion of Halliburton (HAL Quote) and Schlumberger (SLB Quote) makes sense from the energy-services side. They are large-cap, diversified services companies that have their fingers in almost every aspect of the energy biz.

In the exploration and production space, look to companies that have proven reserves and have shown an ability to get more gas out of the ground. Among the large-caps are Anadarko (APC Quote), Devon Energy (DVN Quote), EOG Resources (EOG Quote) and Ocean Energy (OEI Quote).

Among mid-cap and smaller companies, focus on Mitchell Energy (MND Quote), Newfield Exploration (NFX Quote), Cross Timbers (XTO Quote) and Houston Exploration (THX Quote). The list also includes Barrett Resources (BRR Quote), although its pending merger with Williams (WMB Quote) has the stock fully valued.

You don't have to hurry to these names. With most estimates suggesting another three weeks of strong natural gas storage data, these stocks may get cheaper before they begin to heat up for summer.

Raymond James' Adkins provides a solid look at the strategy. "From a stock perspective, it is reasonable to assume that most of the E&P and oilfield service stocks would react negatively to a near-term downturn in commodity [prices]," he says. "We would sit on the sidelines until it is clear that gas prices have bottomed. That will likely occur between May and June. After gas prices stabilize, back up the truck because the ride upward will likely be fast and furious."

Hold on.