What's Driving the Natural Gas Rally?

If you haven't noticed, natural gas prices have soared over the past month and a half, helping reverse a lengthy decline that began in the summer of 2011. Gas futures in New York settled at a 20-month high on Friday, led by colder-than-expected weather that helped reduce stockpiles below the five-year average for the first time since 2011.

Cold weather erases stockpile surplus
March saw uncharacteristically strong demand for home heating because of unusually chilly temperatures. The trend is expected to continue, with MDA Weather Services, a provider of meteorological forecasts, predicting colder-than-usual temperatures in the north-central states and hotter-than-usual weather for Texas and the Southeast for next week.

In the week ended March 29, the U.S. Energy Information Administration reported that 94 billion cubic feet, or bcf, of natural gas were withdrawn from underground storage, exceeding Wall Street's consensus for a draw of 92 bcf. That pushed the amount of working gas in storage down to 1.687 trillion cubic feet, or tcf, a decrease of 779 bcf from a year earlier and 37 bcf below the five-year average.

In addition to bullish storage data, gas price gains accelerated following the release of Baker Hughes' rig count data, which indicated that the number of rigs drilling for natural gas fell by 14 to end the week at 375 -- the lowest level since May 1999.

According to Johan Spetz, an analyst at Goldman Sachs, gas prices will have to rise further in the second half of the year to spur production growth. According to his calculations, prices will need to average about $4.50 per thousand cubic feet in the latter half of the year to balance the market.

Winners and losers
If prices do end up moving higher still, some low-cost natural gas producers stand to see further gains. One company worth keeping an eye on is Ultra Petroleum , a pure-play gas producer whose stock price closely tracks the price of natural gas; since mid-February, shares are up almost 30%.

Ultra was one of the lowest-cost producers last year, with all-in costs of roughly $3 per thousand cubic feet equivalent, less than half the industry average of $6.31. If gas prices rise further, its Pinedale Field and Marcellus assets will become even more profitable -- a catalyst that's sure to send the company's stock higher.

Some companies are already reacting to the surge in gas prices by resuming or ramping up gas drilling. For instance, Encana announced in February that it plans to increase the number of rigs it has running in the Haynesville shale by three this year, because of the play's improved profitability.

Others, however, are opting to wait till prices rise much higher before they divert their resources away from liquids-rich plays.

For instance, Chesapeake Energy recently announced that it has no plans to resume drilling in gassier plays and is instead opting to ramp up operations in the oil-rich Eagle Ford play. Similarly, Devon Energy said it won't be drilling for natural gas at all this year and will instead be devoting much of its capital budget to ramping up drilling in the liquids-rich Permian Basin.

Losers from the natural gas rally broadly include companies whose production costs are heavily dependent on natural gas prices. For instance, consider manufacturers of nitrogen-based fertilizer products, which tend to use copious amounts of natural gas as a primary input for their operations.

The surge in gas prices has been especially brutal for Rentech Nitrogen Partners . At the company's East Dubuque facility, natural gas accounts for nearly two-thirds of ammonia production costs. Not surprisingly, since the surge in natural gas prices began in February, Rentech shares have plunged by about a third.

Keep watching the natural gas space in 2013 to see how high prices may go.

Chesapeake may not drill for gas until prices rise further, but it's coming along just fine in ramping up its oil production. Will the company manage to meet its oil production target 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.

The article What's Driving the Natural Gas Rally? originally appeared on Fool.com.

Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool recommends Ultra Petroleum, owns shares of Devon Energy and 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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