Is Natural Gas Back?

Investors have tried unsuccessfully to call a bottom in the natural gas market for years. Yet in the past month, even as many commodities have fallen sharply, natural gas has bounced significantly -- and it could be just the beginning of a long bull trend for the clean-burning fuel.

Hitting bottom?
When natural gas prices went below the $2 mark last month, they touched a decade low. Yet even with gas fetching bargain-basement prices, many analysts were nevertheless skeptical that the market would recover anytime soon from the huge supplies that unconventional drilling techniques like hydraulic fracturing in shale gas areas have produced. Even traditional natural gas producers from Chesapeake Energy (NYSE: CHK  ) on down started shifting their focus to more profitable oil and gas-liquids projects, shutting in unprofitable dry gas production.

But lately, the relationship between oil prices and gas prices has been turned on its head. Oil has seen its price plunge, bringing down shares of E&P companies from the giant ConocoPhillips (NYSE: COP  ) and Marathon Oil (NYSE: MRO  ) to smaller producers along with it. Yet natural gas prices have become very strong, with the United States Natural Gas ETF (AMEX: UNG  ) rising by nearly a third in just the past four weeks.

Will this trend continue? Let's look at some of the factors affecting natural gas prices.

Fuel switching
One of the main drivers of the recovery in natural gas has come from gas users like electricity-generating utilities switching from coal to gas. At record low prices, gas became highly attractive as a clean-burning power source for electrical generation plants.

But there's only so far gas can rise before switching stops making sense. Coal has also been beaten down lately, and with coal prices having fallen 10% this month, the incentives for utilities to switch to natural gas are less lucrative with every rise in gas prices compared to coal. Natural gas prices may have a bit more room to run, but eventually, it will need to find other demand drivers to keep rising.

Supply
The big decline in natural gas prices came largely from big U.S. discoveries. But overseas development continues and could go a long way toward increasing supplies further.

A look at the international energy arena shows new projects going up nearly everywhere. China expects to start producing shale gas in the next month, while Australia is ramping up reserves. Even India is getting in on the game, although India's largest exploration company expects to need four years of exploratory drilling before commercial production comes online. Africa has proved to be a potential bonanza for shale gas, and South America has its own reserves as well.

One key, though, is that natural gas prices differ greatly from market to market. So even if foreign supplies surge, they'll largely act only to reduce some of the discrepancies between prices in the U.S. and abroad. North American production will be the primary driver of local gas prices.

Liquefied natural gas export
The reason for price discrepancies in the global gas market is that it's tough to transport natural gas. But the big push for liquefied natural gas, which seeks to capitalize on arbitrage opportunities, could reduce foreign premiums on natural gas prices abroad and push U.S. prices higher by taking supply out of the local market.

Cheniere Energy's (NYSE: LNG  ) indirectly owned majority interest in the planned Sabine Pass LNG export terminal is just one of the many projects around the world seeking to use LNG transport to earn profits. If LNG gains traction, then the U.S. lead in shale gas production could lead to massive outflows of natural gas, sending prices higher. But if international production catches up, then the arbitrage opportunities could disappear, making LNG transport less profitable for any markets that have their own gas production.

No sure thing
Natural gas prices have clearly bounced from their record low levels. But with several factors that could push gas in either direction in the future, there's no guarantee that the recent rise is the long-anticipated beginning of a much more powerful move up for the clean-burning fuel. To achieve that, meaningful, permanent shifts in energy demand -- such as a big move toward natural gas-powered transportation -- will need to happen.

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Fool contributor Dan Caplinger looks forward to the day when he gives up his oil furnace for a gas one. You can follow him on Twitter. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Chesapeake Energy. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't leave you feeling gassy.


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