Why This Natural Gas Glut Will End

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The U.S. is currently in the midst of a glut of natural gas and related products, and as a result, prices recently fell to around multi-decade lows. As wonderful as that is to those of us who use the fuel to heat our homes or cook our food, it's a condition that can't last forever.

Like anything else in the market, natural gas is subject to the law of supply and demand, and its price sends signals to both producers and consumers on what to do next. Low prices both encourage consumption and discourage new production, and that combination means that at some point, probably within the next few years, this glut will end.

The potential for decreasing supply
On the supply side, major natural gas drillers like ExxonMobil (NYS: XOM) and Encana (NYS: ECA) recently announced that they were scaling back production because of those low prices. That's to be expected; after all, it costs them money to produce the gas, and if they're not earning a sufficient return on their investment, they'll deploy that cash elsewhere.


That doesn't mean that supply grinds to a halt just because prices are low. Indeed, there are valid reasons to produce, even at today's incredibly low market prices. For instance, Ultra Petroleum (NYS: UPL) has hedges for 2012 on over 150 billion cubic feet of gas, guaranteeing them $4.32 per million BTU on that production. Additionally, many leases for gas drilling have "use it or lose it" clauses, where the company needs to do at least some drilling to keep its access to the property with the gas under it

Also, there's an element of seasonality at work. As the chart of natural gas in storage below indicates, there's typically a buildup of supplies in storage over the summer months and a draw down over the winter as the fuel is used for heating.

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Chart from U.S. Energy Information Agency.

To some extent, producers may be pumping gas out of the ground that's not necessarily economical now, but may well be if prices recover during the winter drawdown.

Where increased demand can come from
Low prices aren't just signals to producers to lighten up at the wellhead -- they're also signals to consumers to come up with new uses for the fuel. Xcel Energy (NYS: XEL) , for instance, is busy converting several of its coal-fired power plants to natural gas. While the conversions are partially driven by environmental concerns, the extremely competitive price of natural gas is certainly helping make the case as well.

And in what may be a signal of a long-term shift in transportation, Navistar (NYS: NAV) recently announced that it expects to offer natural gas powered options across most of its fleet line by 2013. As long as natural gas remains significantly cheaper than oil-based fuels, there's an incentive to convert to natural gas. With around 15,000 new trucks a month needed just to replace trucks that age and wear out of usefulness, a significant base can be built fairly quickly -- if the refueling infrastructure is ready.

Of course, the lack of a nationwide refueling infrastructure does create something of a "chicken and egg" problem for the transportation industry. But still, a significant portion of truck trips are fairly short haul -- a few hundred miles or less. That opens the opportunity for "hub and spoke"-type fueling stations around a manufacturing site, rail depot, or port. Those stations could serve the needs of the short haul fleets in the vicinity, enabling local conversions without a national fueling infrastructure.

Even without new demand coming from places like power and transportation, the chart below shows an incredible price imbalance between the U.S. and much of the rest of the world:

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Chart from the U.S. Federal Energy Regulatory Commission.

With price gaps like that, there's plenty of opportunity to sop up the excess capacity in the U.S. simply by exporting that gas to more expensive parts of the world. Still, the reason those price gaps persist is because it takes time, effort, and money to overcome the regulatory burdens and build out the infrastructure capable of supporting any sort of export scale. Current estimates point to the first significant continental U.S. export terminal coming online around 2016.

Either way -- the glut will ease
Whether it's from decreasing supplies as producers struggle to cover their costs or increasing demand as new uses and markets for natural gas is found, the glut in natural gas will end. It may take a few years, but the signals that the commodity's extraordinarily low price is sending are simply far too clear -- and too tempting -- for it to go on indefinitely.

Interested in the companies listed above? Add them to your watchlist:

  • Encana Corporation
  • Navistar International
  • Ultra Petroleum
  • Xcel Energy
  • ExxonMobil

At the time this article was published At the time of publication, Fool contributor Chuck Saletta owned shares of Ultra Petroleum. Click here to see his holdings and a short bio. The Motley Fool owns shares of Ultra Petroleum. Motley Fool newsletter services have recommended buying shares of Ultra Petroleum. The Motley Fool has a disclosure policy.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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