Natural Gas Is Not Burned Out

Has natural gas gone up in flames?

A quick look at current natural gas prices -- trading at less than $2.50 per million British Thermal Units, or mmBtu -- suggests the early year rally that pushed prices above $10 was nothing more than a short-lived bubble.

Most say natural gas is destined to trade around its traditional hitching post, about $2, give or take a few pennies.

However, while that forecast may be spot-on in the near term, the smart money is suggesting a different course in the coming year.

Take the recent shopping spree by Devon Energy (DVN Quote), announcing two acquisitions to expand its natural gas holdings: First Devon agreed to purchase Mitchell Energy (MND Quote) and then it announced plans to acquire Calgary-based Anderson Exploration (AXN Quote), both at substantial premiums. Devon's chairman, industry veteran Larry Nichols, is clearly betting natural gas will come back.

"The most meaningful thing about this deal is that Devon is a well-respected E&P company that is a savvy acquisition player," said Dan Pickering, director of research at Simmons & Co. and a member of the TSC Energy Roundtable. "They are seeing the same things that everyone else is seeing regarding building inventories and a sloppy gas market short term, and yet they go out and pay a premium."

While it's easy to do deals in the energy arena when markets are strong, Devon's recent action is bold and, for investors, a sign that insiders believe in a strong future for natural gas.

Disappearing Demand

Even as analysts were suggesting a new era of $5-plus natural gas earlier this year, demand was quietly slipping away, eroding hopes for the new natural gas paradigm.

"Funny things happen when you have an unfettered market and you see outlying prices," said Marshall Adkins, director of energy research at Raymond James and also a member of the TSC Energy Roundtable. "This is what we learned: When you take prices up as high as we did earlier this year, you get into no man's land regarding demand fundamentals. The summer demand for gas is not nearly as robust as we thought it would be."

When natural gas prices soared early this year, industrial users switched to lower-cost fuels or, in the case of some aluminum and chemical companies, shuttered factories altogether.

Data from Simmons & Co. show industrial demand for natural gas declined 21% year over year in the second quarter. "Any time you see commodity demand down 20%, you will have a noticeable price impact," Pickering noted. With demand pulled out from under it, gas prices slipped from above $6 to below $4 -- and just kept falling.

The much ballyhooed summer savior for natural gas -- increased power generation -- never materialized.

"What really crushed the gas markets in the past two or three months is that the supply of coal and nuclear power sharply reduced the demand for natural gas-fired generation," Adkins said. "Summer demand never materialized."

Short-Term Pain, Long-Term Gain?

No doubt, recent sub-$3 natural gas prices have investors concerned about the short-term future of natural gas and the companies that produce it. However, combined with strong oil and distillate prices, industrial demand for natural gas will likely pick up as companies that abandoned gas for less-expensive fuel earlier this year are lured back by moderate prices.

Fuel switching to natural gas should help provide support for natural gas prices over time. "You could see sub-$2 gas but that would be very short term," Adkins said. "Demand will come back and I think the longer-term range will be $3.50 to $5.50 going out several years."

How Low Can It Go? Pundits predict the future of natural gas
Analyst/Firm	Nat Gas Cycle Low Price	Nat Gas Price Est. August, 2002
Marshall Adkins, Raymond James	$2.50	$3.50
Tyler Dann, Banc of America Securities	2.28	3.25
Bryan Dutt, Ironman Energy Capital	2.29	3.50
Doug Hohertz, The Mitchell Group	2.25	3.75
Dan Pickering, Simmons & Co.	2.25	3.50
Average	$2.31	$3.50
Source: TSC Energy Roundtable

Other members of the TSC Energy Roundtable agreed. "In the short term, we probably have more gas than we need, which overwhelms longer-term issues, at least for now," Pickering said.

However, those longer-term issues continue to paint a bullish story for natural gas. Demand is expected to grow by about 2%, while current natural gas production growth is closer to 1.5%. And, the plethora of power generation scheduled to come online in the next two years will put more pressure on supplies. "That will be a 3-4 bcf (billion cubic feet) increase in demand on top of a 60 bcf market," noted Simmons' power analyst and TSC Energy Roundtable member Jeff Dietert. "That is not insignificant."

While the short-term picture is uncertain, one pundit said there is a clear message in Devon's recent acquisitions: We are much closer to the bottom than the top in the natural gas markets.

Said Pickering, "You have to sit back and take notice and consider Devon views the longer-term situation as a tight gas market. And, if you are a company wanting to play in the longer term, these are the kinds of deal you have to do now."

Longer-term investors may want to consider the same strategy.