Will Natural Gas Continue to Rally?

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The natural gas market heated up in the past several weeks as the extreme cold weather in the Northeast and Midwest increased the demand for natural gas. Will the price of natural gas continue to rise? And how will the latest developments in the natural gas market affect the performance of leading natural gas producers such as Chesapeake Energy (NYSE: CHK  ) and Devon Energy (NYSE: DVN  ) ? 

Natural gas market is heating up
During the first 10 months of 2013, the total consumption of natural gas was only slightly lower than last year's demand. Consumption in the residential and commercial sectors grew by 18% and 12%, respectively. The rise in consumption in those sectors, however, was offset by the 13.5% decline in demand in the power sector. 

The colder-than-normal weather in the U.S resulted in a staggering increase in demand for natural gas in the residential and commercial sectors during recent weeks. The table below shows the total and average weekly extraction rates from the natural gas working-underground storage from November to mid-January. As you can see, the depletion rate in the past couple of months was the highest in recent years. If this depletion rate remains higher than previous years' pace, this could keep pressuring the price of natural gas this winter.

Source of Data: Energy Information Administration

For 2013, the Energy Information Administration estimates total consumption to have been 2.1% higher than in 2012 -- a record high of 71.2 billion cubic feet per day. The lower-than-normal temperatures during the 2013/2014 winter along with the low storage levels are likely to keep the prices of natural gas elevated in the coming weeks.

Another factor that could have pressured the price of natural gas higher is the drop in supply: The EIA reported several well freeze-offs due to extreme cold weather conditions in parts of the U.S. The current cold weather could result in additional well freeze-offs, which may further tighten the natural gas market and raise the extraction pace from storage. 

But on a yearly scale, the EIA estimates the demand for natural gas will decrease by 2.2%, mainly due to lower heating degree days and declines in natural gas usage in the power sector. This could mean that during 2014 natural gas consumption will drop back down to 2012 levels. 

Conversely, natural gas production is projected to rise by 2.1% during 2014. Therefore, the natural gas market is expected to loosen during the year, which is likely to bring natural gas prices down to below-normal levels. 

During this winter, however, long-term investors might not fully benefit from the recovery of the natural gas market if they were to invest in natural gas ETFs such as the United States Natural Gas Fund (NYSEMKT: UNG  ) . Because of the contango in the natural gas market -- when prices of long-term future contracts are higher than short term-future contracts -- the ETF's value decreases. This drop in value occurs when the ETF switches at the end of each month its near-month natural gas future contracts for next month's contract. A more detailed explanation of this process can be found in a recent article I wrote on this subject. The ETF also addresses this issue in its prospectus, and claims this situation tends to occur during winter.

Nonetheless, natural gas investors could use the ETF as a short-term investment, in which the adverse effect of the contango isn't as severe. For example, in the past two months the gap between the ETF and the price of natural gas was less than half of 1%. 

Chesapeake and Devon Energy
Chesapeake, the second largest natural gas producer in the U.S., cut down its natural gas production by roughly 24% in 2013, year over year. Oil production is estimated to increase by more than 31%. In the fourth quarter, natural gas production is expected to drop by 28%. Further, the price of natural gas reached an average of $3.86, which is roughly 8.5% higher than the price of natural gas in the same quarter in 2012. Thus, the drop in production will more than offset the rally in the price of natural gas. 

Nonetheless, during January natural gas jumped by 26.5% compared to January 2013. Looking forward, if the price of natural gas remains at its current high levels, it could have a strong positive effect on Chesapeake's revenue and profitability in the first quarter of 2014.

Devon Energy is also likely to benefit from the recent recovery in the natural gas market. Devon Energy, much like Chesapeake, reduced its natural gas production and raised its oil production during 2013. During the first nine months of 2013, the company's natural gas production fell by 7% while its oil production rose by 14%. Therefore, the recent recovery of natural gas will have a lesser positive effect on the company's revenue than it had in previous years. 

In conclusion
Natural gas is likely to keep recovering in the coming weeks as the demand for natural gas rises further. Natural gas producers such as Chesapeake and Devon Energy are likely to benefit from this rally and show an increase in revenues in the first quarter of 2014. But on a yearly scale, the natural gas market is expected to cool down, which will pressure natural gas prices and producers.

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Lior Cohen

Lior has been a contributor for the Fool since 2012. His main interests are in commodities, and energy and materials companies.You can follow him on Twitter to stay up to date with his industry analysis. @tradingnrg

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