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Outlook for natural gas prices anything but chilly

A worker checks water levels and temperatures in a series of tanks at a hydraulic fracturing operation at a gas drilling site outside Rifle, Colo. The price of natural gas took off in mid-February, gaining the distinction of being the best performing commodity so far in 2013.

Brennan Linsley/AP

It was a punishing losing streak. The price of natural gas had just climbed above $10 per million British Thermal Units (BTU) in the spring of 2008. But as the effects of the financial crisis began to be felt in the summer of that year, natural gas fell sharply – then kept consistently sliding – for nearly five solid years.

Most other commodities managed to stabilize once the financial crisis was addressed – then enjoyed a genuine boom into the new decade. But natural gas was left out of the party. The big reason was increasing supply. The refinement of the controversial practice of hydraulic fracturing (fracking) suddenly made immense gas deposits within shale rock economic to develop.

As 2013 began, most investors had written off natural gas. But a funny thing has happened. The price of natural gas took off in mid-February and kept going, rising as high as $4.43 per MBTU in late April – a gain of more than 31 per cent. And with many commodities going in the opposite direction, natural gas has the distinction of being the best performing commodity so far in 2013.

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There have been four factors driving this year's rally in natural gas prices – weather, economy, industry and supply, says Robert Mark, an oil and gas analyst at Toronto-based money-management firm MacDougall, MacDougall and MacTier.

"Weather has been very supportive of increased demand in the key consuming regions due to the extended winter," Mr. Mark says. More than 20 per cent of natural gas goes to residential uses – mainly home heating.

Mr. Mark also notes the improving U.S. economy requires more energy, and sustained cheap natural gas prices encourages increased consumption from industry, especially power producers who substitute gas for coal. And finally, because natural gas prices have been low for a long time, capital investment has been discouraged, which has held back supply.

But the key question now is whether the price trend will continue. Already this month there have been signs of growing natural gas inventories in the U.S. market. Those inventory reports have a major impact on the direction of the commodity price, potentially putting a dampening effect on it.

Most industry-watchers have a cautious outlook for the price of natural gas.

"We don't see it running up much more, though it could approach the $5 level," says Greg Bay, president of investment management firm Cypress Capital Management in Vancouver.

"With the new drilling techniques, it puts a 'cap' on gas prices, as more production can be brought on as prices rise," he adds.

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Josef Schachter sees a two-step move for gas prices. Based in Calgary, Mr. Schachter provides oil and gas research for institutional clients, including money-manager Maison Placements.

"We are just coming into a seasonal correction for natural gas prices," Mr. Schachter says. "But we look for much higher prices by next winter, when we expect deliverability to be lower than current field production."

Many gas companies have been cutting costs and production in the past few years in order to stay afloat while the natural gas price languishes. That has put them in a strong position to benefit as gas prices recover. Many are highly levered to the commodity price – modest increases in the selling price will result in a big jump in their profit.

"You need to own the low-cost producers because there is no guarantee that prices are going to rise north of $4.50," Mr. Mark says. "Companies that have been producing profits over the past two years [when selling prices have been low] have proven their worth and are attractive investments."

Mr. Mark says he favours U.S. producers, as they have fewer risk factors such as location, weather and selling-price differentials. In that market, his top picks are Southwestern Energy Co. (SWN-NYSE) and Range Resources Corp. (RRC-NYSE). In Canada, his top pick is Peyto Exploration Corp. (PEY-TSX), which he calls "the best nat gas company in Canada," because of its low cost of production as well as a yield payout. He also likes Tourmaline Oil Corp. (TOU-T) and Painted Pony Petroleum Ltd. (PPY-TSXV), which he cites as a possible takeover candidate.

Mr. Bay at Cypress Capital also likes to play the takeover angle.

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"We have tried to be in companies that would lend themselves to a larger entity buying them out," Mr. Bay says. The names he mentions are Trilogy Energy Corp. (TET-TSX) and Tourmaline, which he says is "not particularly cheap, but its reserves and production would be attractive to larger entities."

In keeping with his prediction for a short-term pullback in gas prices but a rally come winter, Mr. Schachter advises investors to be patient.

"People should wait until fall – there will be a buying opportunity because gas prices will fall as we get the 'shoulder season' correction," Mr. Schachter says. He adds the end of the calendar year is also a good time to find bargains as some investors sell stocks that have had a disappointing year to take advantage of a capital loss for tax purposes.

Mr. Schachter's top stock to watch is Long Run Exploration Ltd. (LRE-TSX) – he likes the track record of CEO Bill Andrew, the location of most of its wells in northwest Alberta where infrastructure is available, and its move toward the more valuable "liquids rich" form of natural gas.

Mr. Schachter's second pick is Delphi Energy Corp. (DEE-TSX), which he notes is a smaller company, but trades at a significant discount to its net asset value. He expects Delphi's production to ramp up in the not-too-distant future.

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