The core belief of this journal is that we remain in the early stages of a long-term bull market in energy-related commodities and stocks. But stocks and commodities in bull markets rarely go up every single day or every single week.

Every great bull market in history has seen its share of corrections, and those selloffs can certainly feel vicious when they occur. That's why there's a major difference between being a long-term bull on energy-related commodities and being a "permabull" that doesn't allow for even a short-term correction.

In the May 5, 2006, issue of The Energy Letter, Protecting Those Gains, I sounded a cautious note on energy-related stocks and recommended strategies for protecting gains. Back then, investors were, by and large, overly optimistic on energy stocks; the stocks were already pricing in perfection, leaving plenty of room for disappointment and little room for an upside surprise.

The catalyst for the ensuing selloff was a growing fear that the global economy was slowing far faster than expected. Slower economic growth spells lower demand for energy commodities of all stripes.

But by September and October, that sentiment had flipped. There were palpable signs of excess pessimism and panic in the energy patch. I saw plenty of pundits calling for an end to the energy bull market.

Although earnings from the energy patch held up well, the stocks were, in general, way off their springtime highs. Valuations had dropped significantly in the summer months, and expectations for future growth had been significantly lowered. As is so often the case, that extreme in emotion, coupled with a lowered bar of expectations, marked the low for the group.

Now I see increasing evidence that there could be acceleration in the trends for oil, natural gas, coal and related stocks. I’m seeing concrete, fundamental reasons to be bullish. The story is no longer one of just overly pessimistic traders and valuation support. Let's examine some of the evidence.

Natural gas prices declined precipitously in the first nine months of 2006. Many people make the mistake of looking only at spot gas prices. (This is the price of natural gas for immediate delivery.)

The reality is that most producers use the futures market to hedge some of their production. I prefer to look at the so-called strip curve for gas--the average price of the next 12 months of futures contracts. Here's a graph of the 12-month natural gas strip curve.

Source: Bloomberg

While the selloff in the strip was never as dramatic as for spot gas, natural gas prices definitely did decline this year. At the end of 2005, prices were hovering just shy of $11 per million British Thermal Units; in September, the strip dropped under $7 briefly.

The main reason for that weakness: excess gas in storage. Last winter was warm--very warm. In fact, it was one of the warmest winters in at least two decades.

Because the weather was unseasonably mild in the US, we used less natural gas than normal. Therefore, with lower-than-average demand for gas during the peak winter heating season, inventories of gas in storage built up in the US market.

It's worth emphasizing that this natural gas storage overhang is a short-term issue only. Longer term, the US is dreadfully short of natural gas supplies.

With production in both Canada and the US in decline or, at the very least, showing little growth, the nation will be increasingly importing natural gas in the form of liquefied natural gas (LNG). But regardless of longer-term dynamics, inventories have weighed on gas for most of this year.

The selloff in gas accelerated in late August and early September as there was considerable talk of a warmer-than-average winter once again for 2006. The idea was that mild weather would simply compound the US inventory overhang picture. This concept was fed by the release of a report from the National Oceanographic and Atmospheric Association (NOAA) that suggested the winter could be warmer than normal.

The NOAA winter weather report predicts a mild winter based on a weather phenomenon known as El Niño. El Niño is a warmer current in the tropical Pacific. During El Niño years, the same regions of the US that are most important to gas demand tend to see higher-than-average temperatures during the winter months.

It’s clear that NOAA is projecting a 33 percent chance or better of a warmer-than-normal winter this year. However, the NOAA report isn’t as bearish for gas as some would have us believe. NOAA’s Oct. 10, 2006, Winter Weather Outlook stated:

From December through February, the lower 48 states can expect about two percent fewer heating degree days than average but about five to 10 percent more heating degree days than last year's very warm winter. (A heating degree day is used as an indication of fuel consumption. One heating degree day is given for each degree that the daily mean temperature is below 65 degrees.)

But there are already signs that the gas inventory picture is beginning to improve. Check out the graph below.

Source: Dept of Energy

The graph shows natural gas inventories for this year compared to five-year average levels. For example, in early January, natural gas inventory levels were running 200 billion cubic feet (bcf) higher than the average for the period from 2001-05. Because of the warmer-than-normal winter, those excess inventories ballooned to more than 600 bcf by May.

But note what happened during the summer and fall months: Those excess inventories dropped off rapidly. As of the most-recent inventory report, excess US gas inventories are now back under 185 bcf. So, while inventories are still high in a historic sense, the inventory overhang is less than it’s been at any other time this year.

Let's put this data into perspective. Each and every day, America consumes about 61 bcf of gas. So, those excess inventories (measured against a five-year average) that created so much consternation earlier this year now represent only around three days’ worth of supply. Therefore, it really wouldn't take much to alter the US storage picture and put natural gas inventories back under average levels.

Bottom line: I’m not saying we shouldn't look at or worry about natural gas inventories. Rather, it’s clear that the inventory picture is now far more bullish than it was just two months ago.

I see the natural gas market well supported in the coming months. With energy stocks still well under their springtime highs and the fundamental picture improving, I see some compelling opportunities for investors.

And strength in natural gas not only helps out natural gas producers but a whole host of related stocks. Services firms will continue to benefit from rising drilling and exploration activity. And coal is a direct competitor for gas when it comes to electricity generation; after a parabolic move higher last spring and a crash in the summer, some coal-mining firms look ready for another big run-up.

© 2006 Elliott H. Gue
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