Model Portfolio timbo56:SSOF1

Wow! The August natural gas (“gas”) contract has fallen from a little over $13 per Million BTU to 10.57 at market close today, about a 20% drop in less than two weeks. Is it going to stay down, or pop back up? In favor of staying down there is increasing production from the U.S. deepwater, reduced demand from industries that supply house building materials, electricity from new windmill farms reducing the need for gas generated electricity and a build of 104 Billion Cubic Feet in the week ending July 11, 2008 (“the last week”).

Even taking these factors into account, however, I believe that we will see a price recovery. If the low pressure wave in the Caribbean turns into a hurricane, we will see an extraordinarily fast recovery. But even if it does not, there are many factors that point to higher natural gas prices.

First, it is important to recognize that because the readings for the government storage survey take place at 9 AM on Friday, the last week was far more affected by consumption on July 4 then July 11. And July 4 is a national holiday in which many businesses are closed and consumption of natural gas tends to be far lower than on a normal weekday. Some may be comparing the build for last week, which was the 28th week of the year, with the typical build for the 28th week of the year. But July 4 generally falls in the 27th week of the year, so this comparison is erroneous. Compared with the typical 27th week, the last week was not a particularly large build at all, being just 6 billion cubic feet above the 5-year average of 98 billion. And the week-to-week change is an inherently noisy statistic, so one week’s figure should not drive big price changes.

Between May 29 and July 3 of this year gas storage went from being 66 billion cubic feet below the 5-year-average storage to 120 billion cubic feet below the 5 year average, despite the spot price of natural gas being above $12 per million BTU for the entire period. The weather was a little warmer than usual, but taking the nation as a whole, it was not tremendously warmer. And gas at above $12 per million BTU creates a far more powerful incentive to avoid gas usage than does the current price of $10.54.

Let us imagine that I had a knob that I could turn to change the spot price of gas, and I was trying to handle that knob so that this country would end up with at least 3.2 trillion cubic feet of gas at the autumn peak, an amount generally considered adequate to get through the winter. After viewing last week’s storage figures, I would have nudged the knob a little in the “lower-price” direction and then continued to watch to see what effect the change would have and what sort of weather we would have. But the market has swung the knob a huge amount and I just do not think that it was justified. Moreover there are long term reasons to be bullish on gas.

Just as deepwater gas is being exploited; all other gas production is declining. So it is a contest between the deepwater expanding production and all other production declining to see whether production will increase or decline. Petroleum production, however, is down from last year, and this could be an indication that gas production is, too. It also seems likely that Canadian gas production is starting to decline, based on declining reserves.

Also, wind power still produces a very small percentage of U.S. electricity production. Changes must be made to the electric grid in order for wind power to become a more significant producer. This will take time. Also, although production of house building materials, such as bricks, is way down, production of goods for export is up, and some of this production is bound to use gas.

More importantly, there is a huge, growing consumption driver for natural gas, and that is tar sands production in Alberta. In a conventional mine, where the tar sands are scooped up and dumped into hot, soapy water, gas is used to heat the hot, soapy water. In steam assisted gravity drainage (SAGD) gas heats the boilers to create the steam that is pumped into the earth to heat and soften the bitumen. In either case, gas is combined with the bitumen to provide hydrogen when the bitumen is cracked into smaller molecules. With the high price of petroleum, a tremendous amount of development money has been directed toward the Alberta tar sands, meaning ever more gas consumption.

Also, the price of gas is now less than half that of petroleum, on an energy content basis (a barrel of petroleum has about 5.8 million BTU). So for any activity where there is a choice, there is now an enormous incentive to use gas to get petroleum or to use gas instead of a petroleum product. I know that in many cities where natural gas is available, some people still have heating oil furnaces. There is now a huge incentive to switch over to gas, and it would not take long to recoup the investment in a gas furnace. Some may choose to use small electric heaters to heat whichever room is occupied. These heaters are cheap and very easy to use. In today’s electricity production environment it is quite likely that much of the electricity generated to power these heaters will come from gas. We will not see much effect from this until late fall, but there are, no doubt, industrial users of petroleum products that now have a huge incentive to shift to natural gas or electricity, where we would see the difference immediately.

Finally, hurricane season has just begun. Just because we have not seen any major gas production damaging hurricanes in the last two years does not mean we won’t have one this year. Also, despite the last two years of relatively light hurricane activity, I still feel that the 2005 season was a harbinger of things to come, and that hurricane activity in general will become more of a problem in the future, as Caribbean and Gulf of Mexico waters get hotter in the summer and take longer to cool down in the fall.

There are a number of ways to make money from an increase in gas prices. There is an ETF, having the ticker symbol UNG, which tracks the price of gas. Also, energy producer XTO Energy, Inc. (XTO) is known for producing a high proportion of gas in its hydrocarbon mix and tends to be affected by changes in gas prices more than other energy producers. I would rate both of these a buy.