Can the Natural Gas Rally Continue?


Natural gas prices are finally on the rise, having soared more than 20% so far this year. On Wednesday, gas prices closed above $4 per million BTUs for the first time since September 2011. Gas prices had remained under $4 per million BTUs for about a year and a half, even sinking below $2 in April last year -- the lowest level in a decade.

The rally was fueled by strong heating demand, as cold temperatures across major U.S. metropolitan areas in March kept gas furnaces burning longer than expected. According to Bentek Energy, demand for household heating rose 30% in March from a year ago, as measured by the number of heating degree-days.

With gas prices at their highest level in a year and a half, traders and investors are wondering whether the rally can be sustained. Let's look at some factors that could lead to a near-term correction in natural gas prices and some of the companies that stand to benefit big time if prices keep climbing higher.

Why the natural gas rally may falter
According to Addison Armstrong, senior director of market research at Tradition Energy, there are four major reasons we could soon see a sell-off in natural gas.

The first is declining demand during spring months. Historically, natural gas demand tends to peak in the winter and fall off during warmer months. Going forward, the combination of reduced demand for home heating and still weak demand for home cooling in the second quarter could contribute to lower prices.

The second reason is an expected increase in nuclear power capacity in the second quarter. The nation's supply of nuclear energy has declined markedly as much greater capacity has gone off line than expected, mainly for maintenance. However, as Armstrong notes, faster-than-expected progress in maintenance and refueling suggests that the second quarter will see much more capacity coming online than previously thought.

The third is a sharp decrease in the number of power plants replacing coal with gas as their fuel of choice. Over the past year and a half, the trend of utility companies shifting away from coal-fired plants toward gas-powered ones picked up strongly. But now, with natural gas prices much higher and coal prices still very much depressed, this trend is likely to abate.

And finally, there may be some end-of-quarter profit-taking, meaning that traders who were long natural gas this quarter will want to close out their positions to lock in their gains.

Companies benefiting from rising gas prices
If a natural gas sell-off fails to materialize and prices continue to push higher, U.S. natural gas producers will be the most obvious beneficiaries.

Over the past year and a half, energy producers sharply curtailed gas drilling because of the poor economics of their gas wells. For instance, EXCO Resources slashed its rig count from 23 as of year-end 2011 to seven as of the end of last October.

Instead, companies focused primarily on drilling for oil and other liquids, which are more profitable to produce. For instance, Linn Energy last year allocated a much greater portion of its capital spending budget toward liquids opportunities. The company mainly concentrated its operations in the Granite Wash play of Texas and Oklahoma, where it targeted a liquids-rich formation known as the Hogshooter.

But the recent rally in gas prices is sure to spur greater activity in gas plays across the country, reversing previous trends.

As the nation's second-largest gas producer, Chesapeake Energy stands to gain significantly if prices rise further. Low gas prices have exacerbated the company's troubling debt situation, forcing it to sell off several of its oil and gas assets over the past year in an effort to raise much-needed cash.

Though the company has allocated 85% of its drilling and completion capital expenditures for 2013 toward liquids plays, rising gas prices may give the company incentive to ramp up drilling in some of its gassier properties, such as the Marcellus, the Haynesville, and the Barnett shales.

Already, there is evidence that rising prices are motivating some producers to ramp up or resume drilling in gassier plays. In February, Encana announced that it was resuming drilling in the Haynesville shale, thanks to wells that have become much more economical. A press release issued by the company stated:

"Because of the low supply costs in this play, Encana expects that the Haynesville will be able to produce solid returns at current natural gas prices. The company currently has two rigs running in the play with plans to increase to five rigs through 2013."

Investors may also want to take a closer look at Ultra Petroleum , one of the lowest-cost producers of natural gas. For 2012, it had the industry's second-lowest all-in costs per Mcfe at just around $3, less than half the industry average of $6.31. With its Marcellus and Pinedale Field assets boasting superior economics and falling well costs, Ultra is sure to benefit big time from rising gas prices.

Whether or not gas prices continue to march higher, Chesapeake has other tricks up its sleeve. In an effort to develop a more balanced production mix, the company has been transitioning away from natural gas production and toward oil. But will the company manage to meet its oil production target for the year and boost cash flow? Or will it languish under the weight of its heavy debt load? To answer that question and to learn more about Chesapeake and its enormous potential, you're invited to check out The Motley Fool's brand-new premium report on the company. Simply click here now to access your copy, and as a bonus, you'll receive a full year of key updates and expert guidance as news continues to develop.

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Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Ultra Petroleum and has options on Chesapeake Energy and Ultra Petroleum. 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 Motley Fool has a disclosure policy.

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