Will the Natural Gas Market Continue to Recover?

The price of natural gas has rallied in recent weeks and has lately passed the $4 mark. Looking forward, will the natural gas market continue to heat up? How may the recent rally affect natural gas producers, including Chesapeake Energy (NYSE: CHK  ) and Anadarko Petroleum (NYSE: APC  ) ? Let's start by reviewing the recent developments. 

Supply and demand of natural gas
During the first eight months of 2013, the total consumption of natural gas remained very close to last year's level. The sharp rise in the residential and commercial sectors was offset by a drop in the power sector. This winter, however, consumption in both of these sectors isn't expected to rise compared to last year.  

On the other hand, supply is projected to rise by 2% compared to last year's winter. This trend could loosen the natural gas market compared to last year; it may also curb the recent natural gas rally. 

Nonetheless, the price of natural gas is likely to rise in the coming weeks as the U.S. enters the winter season. Moreover, if this upcoming winter were to be much colder than the current forecasts, the price of natural gas could rise further. If you're thinking of going long on natural gas through an exchange-traded fund, take into account the disadvantages of investing in such an ETF.  

Natural gas ETFs
Before purchasing a natural gas ETF such as United States Natural Gas Fund (NYSEMKT: UNG  ) , consider its main drawback: under-performing the natural gas price due to the contango in the market. This problem is well explained in detail in an early Fool article. This is a situation in which long-term future contracts are priced higher than short-term contacts.

The U.S. Natural Gas ETF mostly holds next month's future contracts -- as of this month, it's January's future contract. Before the contract expires, however, the ETF sells January's future contract in exchange for February's contract. If February's contract is higher than January's, the market is considered, as stated earlier, in contango.

As a result, the value of the investment in the February contract would tend to increase slower than the spot price of natural gas, or decline faster. In other words, when the market is in contango, the ETF loses money with respect to the movement in the spot price of natural gas. The contango is likely to continue in the coming months: This trend tends to occur during winter times, as stated by the U.S. Natural Gas Fund's prospectus.

Moreover, investing in the U.S. Natural Gas ETF includes a 0.6% management fee. This is another factor that will further lower the return on such an investment.

The chart below shows the movement of the U.S. Natural Gas Fund and the price of natural gas normalized to the end of last year.

Source of data: Energy Information Administration

As you can see, the price of natural gas rose 22% year to date, while the U.S. Natural Gas Fund rose by only 6%. Therefore, investors may want to consider alternative investments to the ETF such as natural gas producers Chesapeake and Anadarko Petroleum. 

The producers
The rally in natural gas prices could benefit Chesapeake in the fourth quarter. In the third quarter, the company's realized price for natural gas rose by 15%; its natural gas production declined by 9%. In total, the company's natural gas revenue rose by roughly 4%. Due to the company's asset reduction and change in policy, its natural gas production isn't likely to rise in the fourth quarter.

Based on the company's current outlook and its performance during the first three quarters of 2013, its natural gas production may reach 260 Bcf, which is a 7% drop from the fourth quarter of 2013.

The price of natural gas is likely to be only 2% higher than last year. In total, revenue from natural gas may fall by roughly 5%. Despite the drop in production, natural gas and NGL still account for nearly 48% of Chesapeake's revenues from  production. 

Anadarko Petroleum continues to expand its natural gas operations: The company's natural gas sales grew by 31% during the third quarter. Most of the growth in sales was from the sharp rise in the realized price of natural gas -- a 25% rise.

The company's production grew by roughly 5%. The volume of production is expected to remain elevated this year. One of the reasons for the rise in production is the commencement of Anadarko's 200 million cubic feet per day Brasada natural gas processing plant. The moderate rise in the price of natural gas along with the expected rise in production could positively affect its natural gas revenue in the fourth quarter.

These two companies are likely to benefit form the rally in natural gas prices in the coming months. They could also serve as alternative investments to the ETF.  

Takeaway
The natural gas market is heating up for the winter, and the sharp rise in prices is likely to continue in the coming weeks. But the current weather forecasts suggest demand for natural gas won't rise as sharply this winter. This could result in a slowdown in the recent rally. Nonetheless, the ongoing recovery of natural gas is likely to benefit companies such as Chesapeake and Anadarko Petroleum.

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