Oil Defies Bearish Sentiment: Will Natural Gas Follow?

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"While it's hard to see oil prices doubling in the next year. . .it's quite feasible for U.S. gas from these levels."

Thanks to OPEC discipline, crude is now breaking out of its recent trading range. As with many commodities right now, the market is struggling to reconcile the reality of short-term demand destruction with the prospect of medium-term supply destruction as key development projects are postponed or canceled.

After a relatively strong move versus other assets so far in 2009, where to now for oil, or does natural gas offer better prospects?

Oil has rallied on OPEC supply restrictions but remains below marginal production costs in the $60-65 area and above cash costs of $30-$35.

It seems too early for a break-out from the recent price range, at least until we get clearer evidence of demand picking up in the U.S. and the scale of an accelerating Chinese economic slowdown is evident. Medium-term, of 100 key OPEC production projects announced in early 2008, 35 have been delayed; oil infrastructure spend is down 12%-15% in a year, making a spike in prices to $75-$100 as global recovery takes hold in 2010 and beyond very likely.

If, like me, you think the U.S. economy risks an upside growth surprise into 2010, and China a downside one (the latest IMF GDP forecast is 6.5% and I'd be a seller), then natural gas would seem a better energy play. Natural gas prices have tumbled this year, as a steep drop in U.S. industrial consumption has undermined demand.

However, dwindling production is starting to outpace slumping demand and the rig count has halved since last September to under 1,000 according to Baker Hughes. Natural gas futures for delivery in early 2010 are trading at a 50% premium to the April contract, but even that may not discount the scale of the supply squeeze looming.

With so many rigs coming offline, fourth-quarter gas production could decrease by over 5%, way in excess of the predicted demand fall.

Against this background, and particularly if the U.S. economy stabilizes as I expect by year-end, it's quite possible natural gas prices will soar from here, perhaps back above $7/btu by early 2010. While it's hard to see oil prices doubling in the next year absent a huge supply disruption, it's quite feasible for U.S. gas from these levels. Well-financed and unhedged natural gas plays should deliver excellent returns in that scenario but given recent downward momentum, watch for signs of the price leveling out through the seasonally weak summer months for a clear lead.

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