In the last six weeks natural gas futures prices have jumped from a modern day low to nearly $5 per thousand cubic foot (Mcf) as commodity traders and investors started to cover their short positions in this fuel as the days moved closer to the beginning of the winter heating season. The jump in the gas price ends what has been an extended price slide that started back in summer of 2008 when prices were in excess of $13 per Mcf and early signs of the developing global recession emerged.

The traders and investors who have been covering their negative bets on natural gas prices have been motivated by signs the nascent U.S. economic recovery is gathering strength, especially among sectors such as automobiles and home construction that are large consumers of natural gas and its components as feedstocks for petrochemical materials. Additionally, there was the realization that the ratio of crude oil to natural gas prices, which at one point this summer stood at 27:1 (27.08) in contrast to the inherent energy- value ratio of 6:1, was way out of line historically and certainly unsustainable.

At the start of 2009, the oil-to-gas price ratio stood at slightly under 8:1 (7.94). It subsequently dropped in early January to the low so far for the year of 7:1 (6.79). Since that point the ratio has climbed steadily, reaching its peak on September 3rd. After falling to a recent low of 13.67, the ratio has bounced around due to volatility in both crude oil and natural gas prices, but it seems to be locked into a range of 14 to 15:1. The big question is with winter energy demand about to arrive will cold temperatures drive natural gas prices higher while at the same time crude oil prices remain stable, or possibly weaken further, given the continuing sluggish economic recovery?

Natural Gas Is Historically Cheap Even After Recovery; sources: EIA, PPHB

When we look at the ratio of crude oil to natural gas prices for the past 15 years, it is interesting to note how the ratio has become more volatile and higher in recent years following almost a dozen years of a relatively stable relationship fluctuating around a 7:1 ratio as shown by the dark blue line from 1994 up until 2006 on the accompanying chart. The most recent years have demonstrated considerably greater price volatility between the two energy fuels. It appears the ratio averaged closer to 11:1 from 2006 through 2008. Volatility in the ratio has exploded in 2009. We have marked the low, high and current ratios with small red lines. It was this volatility and the extreme undervalued nature of natural gas that enticed more and more investors and traders into the commodity trade of the decade, which was to buy natural gas futures while at the same time selling crude oil futures. For significant parts of this year that trade didn’t work, but in recent weeks it has. Part of the success of the trade has been the calendar working against commodity traders who earlier in the year had sold natural gas futures with the expectation that gas prices would continue to fall. If they sold them early enough in the year, then they had profits locked in when natural gas prices started to climb. As time passes, bringing the start of the winter heating demand season closer, the impetus for higher natural gas prices strengthens. As a result, these commodity traders are now covering their short positions by buying near-month natural gas futures adding upward pressure to the gas price.

If one looks at the current prices for physical deliveries of natural gas, there is almost a $1 spread between them and the current November futures price. If we average all the physical gas price points as of October 8th, contained in the Enerfax Daily schedule, it comes to $3.98 per Mcf. This is when the November natural gas futures price traded for $4.96, or a spread of $0.98. This spread is truly reflective of the near-term oversupply situation for natural gas and the optimistic demand outlook associated with the futures price.

The nearly 100 percent increase in natural gas prices since the beginning of September seems counter-intuitive given the industry’s fundamentals. Natural gas storage facilities and pipelines are nearly all at full capacity forcing gas producers to involuntarily shut-in some of their current production. In other words, near-term industry fundamentals suggest the market should be experiencing weaker natural gas prices, which is consistent with the physical gas prices. On the other hand, the intermediate and longer term outlooks for natural gas demand point to higher prices in the future.

The brighter over-the-horizon outlook reflects a universal belief that industrial demand for natural gas will recover with the economy and the recent growth in gas production volumes will slow and eventually reverse as the impact of the significant cutback in gas-focused drilling takes its toll on output.

Rigs Drilling For Gas Have Been Cut In Half; sources: Baker Hughes, PPHB

From the peak in natural gas drilling activity, the gas-oriented rig count has been cut by more than half. In recent weeks the number of rigs drilling for natural gas has begun to rise. It is this rig count increase in the face of an essentially stable natural gas production level that has investors, commodity traders and industry people puzzled. While a simple graph of onshore natural gas production is showing a decline since late last year, overall gas production has remained relatively flat for the past nine months as production from the Gulf of Mexico has risen to offset the decline in onshore gas production.

After dropping due to Hurricane Ike last September, Gulf of Mexico natural gas production has recovered and is now above the declining trend line that extends back to the start of 2005. In fact, current gas production is back to where it was at the start of the summer of 2008. The recovery and subsequent production growth of offshore natural gas helps explain why total U.S gas production has remained healthy in the face of weak prices for most of this year.

What continues to be absent from the dynamics of the natural gas market is a sustained pickup in industrial gas demand. Increased heating-related gas demand is inevitable as winter arrives. The issue will be the amount of heating demand increase if other economically-sensitive gas demand remains dormant. A recent forecast by Matt Rogers of Commodity Weather Group suggests that the U.S. Northeast may experience its coldest winter in a decade due to the development of a weak El Niño in the southern Pacific Ocean region. Mr. Rogers point is that 75 percent of the time a weak El Niño develops, colder than normal temperatures are felt in this region of the country. Of course, there is a 25 percent chance that it won’t develop.

When an El Niño develops, which it does periodically, the path of the upper atmosphere’s jet stream across North America is altered. Typically the alteration involves the jet stream dipping lower on the continent, i.e., shifting from Canada down into the United States, which allows Arctic cold weather to move further south than normally and into the Midwest and Northeast regions of the country. The challenge with predicting this jet stream shift is whether it becomes a more permanent shift during the winter months or only shifts occasionally.

Even the Farmers’ Almanac is calling for a colder winter than in recent years for at least two-thirds of the nation. Importantly, that means more periods of bitter cold weather for two of the major populous regions of the U.S. That should boost natural gas demand. The one naysayer seems to be the Energy Information Administration (EIA) that is calling for heating bills this winter to be about 8 percent lower than last winter due to both milder temperatures and lower oil and gas prices. The EIA says it expects winter temperatures to average 1 percent warmer than last year – a sharp contrast to the independent weather forecasters. Maybe their forecast is tied to their view about the role of global warming. The real problem for the natural gas industry is that it really needs a recovery in industrial gas demand to help smooth out the industry’s supply/demand trends, and the latest government economic statistics suggest a mixed bag in that regard.

So far this year, natural gas prices have fallen from $6 per Mcf at the start to a recent low of $2.50 before rallying back to $5 in recent days. These prices are a far cry from the $13-$14 per Mcf prices achieved in the halcyon days of the summer of 2008. The extended price decline, while partially explained by the fall in industrial gas demand, has largely been attributed to continued over-production of natural gas from the industry’s highly successful gas-shale drilling efforts that are spreading across the country. The growth in the past several years of natural gas production associated with these successful gas-shale developments reversed an eroding production profile for the industry that had existed for decades. The questions facing the industry now are whether gas-shale production will eventually overwhelm traditional natural gas drilling and production efforts and whether it is possible that the U.S. becomes a net gas exporter at some date in the future.

To help arrest the growth in natural gas production and boost gas prices, producers have cut back their drilling activity by roughly 50 percent since last fall, but because gas-shale wells are so prolific compared to conventional gas wells, the drilling reduction appears to be having limited impact in slowing production growth. In the latest monthly data from the EIA’s industry survey, gas production does appear to be falling, at least on land. The challenge, however, is to try to decipher whether this production decline is real or involuntary.

Natural gas storage as of September 25th was at 3,589 billion cubic feet (Bcf) out of an estimated industry-wide capacity of 4,000 Bcf. The problem is that natural gas storage facilities are spread around the country in the eastern and western consuming regions and in the gas producing areas. Additionally, there are limitations on the amount of natural gas that can be transported via pipelines from the producing regions to the consuming markets. As a result of these infrastructure limitations, the overall storage capacity ratio may not accurately reflect the true impact that high storage volumes are having on gas production.

When we look only at industry-wide storage volumes plotted against total natural gas production, the surge in storage appears to be coinciding with a flattening, and now declining gas production.

The level of gas storage volumes and the amount of injections shows even more clearly how the nearly full storage levels are impacting gas production.

As total gas in storage has climbed to a record high, even after a roughly 100 Bcf of new storage capacity added, injection rates have fallen to low levels as there is little appetite or room for more gas. Some portion of the fall in current natural gas production has to be associated with involuntary production curtailments. The challenge is to determine how much of a fall-off is due to curtailments and how much is a fall in well productivity.

To begin to look at this issue, we were provided data for monthly natural gas production in Texas. At this point we cannot vouch for its correctness, but we plotted it against the initial daily production by month for the state coming from the EIA’s Form 914 survey of gas producers. Lastly, we went to the Texas Railroad Commission web site and took only the 2009 monthly natural gas production data currently available, converted it to daily production figures, and plotted that data. The point of the exercise is to show that all these Texas natural gas production data sources are consistent in their pattern – steadily down. The interesting thing is to look at the shapes of the curves for 2009. The production data provided to us shows flat production for several months and then a steep decline. The EIA’s data shows a decline but at a more modest pace for all of 2009. The Texas Railroad Commission data shows a steady decline, but at a much faster rate than the EIA data. Unfortunately, these curves don’t answer the question: Is the decline due to falling natural gas well productive capacity, or is it a function of low prices, or is it due to involuntary cutbacks due to rapidly filling storage capacity?

Since a lot of Texas natural gas tends to have higher finding and developing costs we suspect that some of the fall in gas production has been due to the weak gas prices. Producers must have been looking at their costs versus market prices and deciding to shut-in gas production. But some of the fall off in production has to be associated with older, less productive wells. Our guess is, however, that between these two explanations, the former is more important than the latter, but we cannot prove this conclusively.

So while we wrestle to understand the current falling gas production figures, we are drawn back to looking at what the industry is doing with its drilling effort. The sharp fall-off in gas-oriented drilling rigs will eventually take a toll on production, but for the time being one has to be concerned about the recent uptick in the gas-oriented rig count before we know why production has fallen.

At the same time, when we look at gas production compared to the number of rigs drilling horizontal wells, although we know not all rigs drilling horizontally are seeking natural gas, the strong upturn there could be a precursor of future gas supply challenges since the gas- shale wells, drilled horizontally, are so much more productive than conventionally drilled gas wells.

The chart of gas production versus the total number of rigs drilling either directionally or horizontally shows a potentially less ominous supply challenge for the natural gas industry.

The recovery in natural gas prices back to the $5 per Mcf level is certainly a positive for the industry. The latest production figures suggest that gas supplies are shrinking, but the weekly gas injection figures continue to reflect the impact of nearly full storage capacity. We can safely assume that gas production volumes are being reduced due to involuntary well shut-ins. What we don’t know is whether the industry is Wiley Coyote having run off the mountain road and is now suspended in air waiting to fall.

Is natural gas production about to drop like a rock? Or is it possible we just need to get rid of some of the gas storage volumes with cold weather allowing producers to ramp back up their shut-in wells? That last scenario will come with current or higher winter gas prices. The former scenario suggests a natural gas price that rockets straight up. Unfortunately an exploding gas price will bring with it the seeds of the next price collapse.

We reiterate our view that without a healthy economy the natural gas market will struggle to regain solid economic footings.

Allen Brooks is a managing director at Parks Paton Hoepfl & Brown, a Houston-based energy-focused investment banking firm. This article previously appeared in the October 13 issue of Musings From the Oil Patch.