Natural Gas Supply on the Rise

The federal government’s Energy Information Administration (“EIA”) reported an in line increase in natural gas supplies, attributable to relatively warm temperatures in most regions that led to robust electric generation demand for the commodity.

Stockpiles held in underground storage in the lower 48 states rose by 40 billion cubic feet (Bcf) for the week ended August 20, 2010, within the forecasted range of 37 – 41 Bcf increase. The latest build compares with last year’s net injection of 53 Bcf and the 5-year (2005-2009) average of 59 Bcf for the reported week.

The current storage level, at 3.05 trillion cubic feet (Tcf), is down 198 Bcf (6.1%) from the last year’s level, but remains 177 Bcf (6.2%) above the five-year average. Natural gas supplies have exceeded the 5-year average for this time of year in each of the past 22 weeks (since March 26, 2010) and are not far from the last year’s record highs at that time.

Though the ongoing surge in the commodity’s demand (on account of hot weather) has erased a hefty surplus over last year’s inventory level, following a high of 101 Bcf for the week ending April 23, the specter of a continued glut in domestic gas supplies still exists, with storage levels remaining 6.2% above their five-year average. In fact, the latest build, though in line with market expectations, has send natural gas inventories above the 3 Tcf mark for only the second time since January 1, 2010.

Further pressurizing the commodity is the rapid rise in the number of drilling rigs working in the U.S. (the natural gas rig count has climbed 48% from the seven-year low reached last July) that signals a supply glut later this year in the face of consumer worries regarding high unemployment and economic recovery.

More importantly, production from dense rock formations (shale) through novel techniques of horizontal drilling and hydraulic fracturing remain robust. In fact, the share of shale gas in the country’s natural gas production has shot up from zero to 8% in the last decade. This has created a massive oversupply, compelling natural gas prices to slash from $13 per million Btu (MMBtu) four years ago to sub-$4.0 per MMBtu today (referring to Henry Hub spot prices). As there are more technological breakthroughs, shale gas has become viable in some cases at just $3 per MMBtu.

There are concerns among traders that the market will be oversupplied in the short to medium term, with rig counts going up and onshore production increasing. The lack of tropical storm activity in the Gulf of Mexico (an energy-rich region representing about 11% of domestic gas output) is also expected to hold back natural gas price increase. This translates into limited upside for natural gas-weighted companies and related support plays.

Therefore, we maintain our cautious stance on natural gas-focused exploration and production (“E&P”) players such as Anadarko Petroleum Corp. (APC), Chesapeake Energy (CHK), EnCana Corp. (ECA) and Devon Energy Corp. (DVN), as well as natural gas-centric service providers such as Halliburton Company (HAL).

Additionally, we remain skeptical on land drillers such as Nabors Industries (NBR). We believe that the overhang from continued oversupply will lead to an extended period of weakness for North American natural gas prices, resulting in reduced drilling and fracturing activity. In particular, this will affect the fortunes of Nabors – the leading North American land drilling contractor.

All the above-mentioned companies currently retain a Zacks #3 Rank, which translates into a short-term Hold rating.

HALLIBURTON CO (HAL): Free Stock Analysis Report
NABORS IND (NBR): Free Stock Analysis Report
CHESAPEAKE ENGY (CHK): Free Stock Analysis Report

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