Natural gas spot prices are up around 35% from the lows in May, and gas-focused equities have risen 10% over the last month, but is it the beginning of a rally or merely a blip?

FBR Capital Markets energy analysts last week reviewed the data and considered the possibility of a gas price rally based on the hotter temperatures, but they also measured the “headline risks” related to hydraulic fracturing in gas shale plays that are taking shape in several parts of the country (see related story).

For a “bullish argument,” FBR Capital’s Rehan Rashid and Saurabh Lele pointed to these facts: the “hottest summer in 30 years, deepwater event affecting offshore production and stable industrial production…” However, there’s been no decline in onshore drilling rig data, which forms the basis for the bears’ argument.

“Our recent conversations with investors is suggesting sentiment is more bearish for the near-term outlook for equities and the commodity, especially given the backdrop of [a] run-up in equities off of the lows and no real change in near-term fundamentals,” said Rashid and Lele.

For U.S. gas markets, they noted, “nothing has changed but the price. The gas rig count (both horizontal and vertical) is still very close to recent highs. Indeed, summer is expected to be hot but fundamental nonseasonal supply/demand balance still points to an oversupplied market near term.

“An all-time-high coal inventory (two-month versus one-month average last three years) also means that there are competing sources of Btus out there for electric generation. As such, we are feeling the sentiment turn negative again after a 35% rally over the last month.”

The possibility of increased shale gas (or deepwater) regulation, would mean “higher prices for the commodity,” said the analysts. “Of course, anything that would lead to lower drilling activity would mean contraction in supply. However, the impact on the spot market, in our opinion, will not be felt for at least another two quarters.”

Based on their talks with onshore exploration and production companies, cost pressures also are “increasing in aggregate,” said the FBR Capital team. “This time around, the marginal demand driver and hence the culprit for overall tightness in service capacity (specifically hydraulic fracturing) is being blamed on an increasing Eagle Ford [Shale] rig count.”

In last week’s Natural Gas Kaleidoscope, Barclays Capital’s Jim Crandell, Biliana Pehlivanova and Michael Zenker agreed that the 2010 cooling demand season was “off to a scorching start.” Warmer-than-normal temperatures in May and June “charged demand” and strengthened hopes for the gas bulls.

“While summer temperatures are of lesser importance than their winter counterparts in swinging demand, a hot summer can still provide a spark for the gas market,” said the Barclays trio. “Electricity demand, driven largely by air conditioning needs in the summer, has recently captured the market’s imagination as a bullish story for natural gas, which is used in generation for its flexibility in meeting peaking demand.”

Summer temperatures “typically” hit a seasonal high in mid-July, noted Crandell and his colleagues, but “strong anomalies have already contributed incremental cooling demand.” May had 16% more cooling degree days (CDD) than the 10-year norm and 35% more than the 30-year norm, and through the first weeks of June, “CDDs have deviated strongly above normal, 23% above the 10-year norm and 29% more than the 30-year norm.”

Prompt prices “rallied smartly” in the past six weeks as warmer temperatures added demand, and that may risk the generation share that gas grabbed from coal in 2009, noted the Barclays team.

“Switching is responsive to price and at a level of $5/MMBtu, we would argue that the loss of switching is a larger demand factor than added weather-related demand. Given that coal displacement is difficult to read, we believe the market is likely to under appreciate this factor over the course of injection season.”

As in 2009, prices will “hunt” for the level of coal displacement that “produces a storage finish that is within capacity,” wrote the Barclays trio (see NGI, June 21). In a review measuring the amount of gas-fired output against total generation with the corresponding average prompt gas price for each month in 2009, “not surprisingly, gas-fired output deviated most strongly from trend when prices were at either end of the extreme,” said Crandell and his team.

“As such, the effect of a hot summer on demand could be cooler than the market is anticipating if prices continue to heat up.”

Based on the forecasts for this summer, it’s going to be a scorcher, said Chief Long-Term Meteorologist Joe Bastardi (see related story). “Average summer temperatures will rival some of the hottest summers ever recorded across the eastern half of the nation,” he said. The demand on energy also will be in full force, he said.

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