The Time is Right for This Sector

Careful what you wish for. That’s the hard-learned lesson gleaned by investors and industry executives seeking their fortune in natural gas. Just a few years ago, they wished to find more natural gas in the ground and under the sea bed. They did, hitting mother lode after mother lode. Now, we’re awash in natural gas and a glut has led to a sharp slump in prices.

Could that slump be coming to an end? A host of factors are lining up to help boost demand and possibly curtail supply of this relatively clean burning energy source.

If you live in the Northeastern United States, then you can already guess what Factor No. 1 is. Furnace-like conditions are leading to a sharp spike in electricity usage. Several long-term weather forecasting services predict temperatures will stay above average clear through the end of August. If that’s the case, the amount of natural gas in storage could start to come down quickly and that should start to provide a tangible lift to prices.

Factor No. 2 relies on the “bath-like” conditions of water temperatures in the Gulf of Mexico. Meteorologists have noted a strong correlation between water temperatures in the Gulf and strong hurricanes. And based on that, they think that we’ll be in for a doozy of a hurricane season. The peak of storm activity is expected to begin in a few weeks and last into October.  Recall that in 2005, hurricanes Katrina and Rita caused natural gas prices to soar, as a good deal of production was taken off-line. The Department of Energy estimates a median 166 billion cubic feet of gas production could be lost during the 2010 hurricane season — nearly three days of domestic supply.

#-ad_banner-#Factor No. 3 is more of a wildcard: the Obama administration has disappointed industry watchers for failing to provide a greater boost to natural gas-powered vehicles. But the industry isn’t waiting around. Honda (NYSE: HMC) already sells natural gas vehicles, Fiat has announced plans to do the same with the next generation of Chrysler cars and trucks, and major fleet operators such as UPS (NYSE: UPS), FedEx (NYSE: FDX) and AT&T (NYSE: T) are quickly converting hundreds of vehicles to run on natural gas. Where will they fill up? Clean Energy Fuels Corp. (Nasdaq: CLNE) is building natural gas fueling stations. If natural gas can secure a reliable role as a transportation energy source, then prices would likely find a floor solidly above current levels.

Supply restraint
For natural gas producers, a re-balancing of supply and demand can’t come fast enough. Even though they were sitting on newly-discovered massive energy fields, they steadily throttled back production in a bid to keep a lid on supply. Trouble is, demand also dropped, and many of the natural gas fields that did come online produced a lot more gas than expected. But it’s only a matter of time before the restraint pays off. Natural gas fields have a finite shelf life and eventually yield smaller and smaller amounts of gas. As older wells get depleted, total output should drop, allowing prices to rise back up.

You get a sense of the anticipated supply and demand trends by looking at futures prices. Contracts for delivery of natural gas that expire in August have already risen from around $4.15 per thousand cubic feet to a recent $4.81. Looking out 18 months to January 2012, those same contracts go for around $6. Current prices likely account for Factor No.1 noted above (warming summer weather), but if the second and third factors cited above come into play, natural gas futures contracts could quickly move toward the $8 mark.

Action to Take –> There are a host of ways to play the resurgent natural gas sector. The U.S. Natural Gas Fund (NYSE: UNG), at a recent $8, is up roughly $1 from the spring, yet nowhere near the $60 levels seen just a few years ago when natural gas was trading in double-digits.

Or you could buy a basket of natural gas plays through the First Trust ISE-Revere Natural Gas Fund (NYSE: FCG). The index fund carries fees of up to 0.60% and concentrates on firms that are mostly exposed to natural gas prices.

A number of energy firms have exposure to both and oil and gas, and would not rally as sharply in an environment of natural gas prices. For investors looking for high reward with high risk, can check out Chesapeake Energy (NYSE: CHK). Chesapeake employs a hefty amount of debt leverage, which really hurt the company when gas prices slumped, but would magnify earnings if prices were to rise.