Encana Corporation (ECA)

[frenchee]

Natural Gas: Big Risk Could Mean Big Opportunities
posted on: October 15, 2007 | about stocks: ECA
It is hard to imagine a worse environment for natural gas producers: prices are low, inventories are high, the weather is balmy and the Atlantic hurricane season has been uneventful.

To make matters worse, the threat of higher royalty and tax rates on oil and gas projects in Alberta has encouraged companies to announce big cutbacks in drilling activity. When they refuse to drill, the implication is clear: they believe gas prices are going nowhere.

But for any investor who likes the thought of an investment that is unlikely to get much worse, natural gas stands out as one of the few opportunities among commodities -- and the skepticism among producers is one of the big reasons for hope.

"I think that one of the reasons why natural gas may rally like crazy this year is because people are cutting back on production," said Phil Flynn, energy analyst at Chicago-based Alaron Futures and Options.

"We have a lot of [gas in] storage. But I have been in the industry long enough to know that when people start cutting back on production that is usually a catalyst for higher prices."

Simply put, low prices make production uneconomical, so companies drill less and produce less, creating shortages that drive prices back up.

Over the past two years, natural gas prices have bounced between US$6 and US$8 per thousand cubic feet, down from about US$11 at the beginning of 2006. The price is currently U$7 per mcf -- or US$1 less than what is economical for new projects in Canada, according to some estimates.

Drilling in Canada is at a low level already and production is declining. However, Henry Cohen, president and chief executive of Toronto-based Full Cycle Energy Investment Management, believes that drilling activity in the United States needs to fall considerably further for the production-cutback theory to blossom.

"The level of drilling activity in the United States has been slowing down [over the past four weeks], but the level it has been running at until this time is too high to correct the situation," Mr. Cohen said. "You're at least replacing, if not growing, production."

He estimates the rig count has to drop by another 7% or so before things get interesting -- which should happen. Of course, a long, cold winter will also help the situation.

Already, Canada's largest producers, such as EnCana Corp. (ECA), have seen their share prices rise sharply from their August lows, driven partly by the hope that natural gas prices will improve.

However, smaller producers, who are more vulnerable to price volatility because of lower cash reserves and an inability to trim production, are being devastated. For example, Kereco Energy Ltd. shares are down more than 40% this year. This is where the biggest risks are, but also the biggest opportunities.