Gas Supplies Fall at Slower Rate

In its weekly release, the Energy Information Administration (EIA) reported an 86 billion cubic feet (Bcf) decline in natural gas supplies for the week ended Jan 22, 2010. The inventory decline, though smaller-than-expected, was the eighth in as many weeks. This has finally started to erode the record-high storage amounts, as frigid temperatures continue to chill major gas-consuming regions in the U.S.

Though the heating season officially began on Nov 1, 2009, net injections continued through November on a national basis. As a result, until recently, gas in storage remained well above the normal range at this time of the year.

However, the ongoing surge in the commodity’s demand has erased a hefty surplus over the five-year average inventory level and significantly trimmed the excess over last year's level.

The current storage level, at 2.52 trillion cubic feet (Tcf), is up 5% from last year's level and 3.6% above the five-year range (as clear from the following chart from the EIA). Current stocks are 120 Bcf above last year’s level and 87 Bcf above the five-year average.

Continued strong domestic production (from a number of unconventional natural gas fields) and recessionary consumption (due to the economic downturn), particularly in the industrial sector, are at the core of the commodity's current woes. Stockpiles went on to create new highs last year as the economic downturn ate into demand, and natural-gas producers continued to unlock new supplies from onshore natural-gas fields known as shales.

Months of mild weather further weakened demand for the fuel to heat homes and businesses. As a result, natural gas prices (referring to Henry Hub spot prices) trended down to a 7-year-low level of sub-$2 per million Btu (MMBtu) in Sept. 2009.

However, on the back of sustained inventory drawdown, the commodity has staged a phenomenal recovery since then, currently hovering around the $5.50 per MMBtu level. Things appear to be getting better for the natural gas players with the belief that storage levels are likely to exit the current heating season at lower levels than expected.

Nevertheless, we are not fully convinced about the sustainability of natural gas’ recent gains, as the specter of a continued glut in domestic gas supplies (storage levels remain 3.6% above their five-year average) is still expected to weigh on results and the inventories remain higher compared to averages for this time of year. This translates into limited upside for natural gas-weighted companies and related support plays.

Given the depressed state of the commodity, the lower-than-expected drop in reserves (which was also significantly below the 5-year-average drawdown of 179 Bcf and last year's withdrawal of 184 Bcf) pulled down natural gas futures prices on the New York Mercantile Exchange (NYMEX).

We are also concerned about expectations of warmer spells of weather this winter. The demand for natural gas for heating is likely to remain subdued during this period.

Therefore, we maintain our cautious stance on natural gas-focused E&P players such as Chesapeake Energy (CHK - Analyst Report), Anadarko Petroleum Corp. (APC - Analyst Report) and Devon Energy Corp. (DVN - Analyst Report).

We also remain Neutral on land drillers such as Nabors Industries (NBR - Analyst Report) and Patterson-UTI Energy (PTEN - Analyst Report), as well as natural gas-centric service providers such as Halliburton Company (HAL - Analyst Report). Although we expect the land rig count to continue with its steady rise during 2010, the large amount of excess capacity in the sector will weigh on dayrates and margins well into the year.

Oil majors like BP Plc (BP - Analyst Report) that have significant natural gas operations are also expected to remain under pressure until pricing and demand improve further.

All the above mentioned companies currently has a Zacks Rank #3 (Hold), meaning that these stocks are expected to perform relatively the same as the overall market during the next 1-3 months. Therefore, investors should maintain their current positions in the stocks over this time period.

Read the full analyst report on CHK

Read the full analyst report on APC

Read the full analyst report on DVN

Read the full analyst report on NBR

Read the full analyst report on PTEN

Read the full analyst report on HAL

Read the full analyst report on BP