As far back as early 2011, some voices in the industry were recommending a long position on natural gas in the face of a weak domestic gas market. Even though the oil-to-gas price ratio has widened, and gas volumes have not fallen off despite rig redeployments to oily plays, it hasn't been hard to find contrarian investors willing to buy gas now.

Private-equity firms, for example, have already started to back management teams having long-gas business plans, particularly in the wake of 2011's big-name corporate mergers—deals primarily driven by buyers' desire for shale-gas plays.

But recent reports from Barclays Capital and Simmons & Co. International suggest a gas-market turnaround won't occur in 2012, and it may not surface in 2013, either. Barclays' analysts believe market circumstances in the near future will put the Nymex gas price at $3.80 per thousand cubic feet (Mcf) for 2012, and even lower for 2013. Prices might only begin to retake $4 by 2015. At press time, the 12-month strip was still below $4.

Growing U.S. supply has been offset by declining LNG deliveries to North America, growing exports to Mexico, and falling exports from Canada.

One big problem

There is only one problem with natural gas: there is too much of it. According to Barclays, U.S. supply growth has exceeded demand growth significantly and consistently for the past several years. And the firm’s analysts don’t look for a change any time soon.

"The biggest factor driving the change in the outlook is where we thought there could be a migration away from dry gas to oil," says Michael Zenker, managing director of commodities research for Barclays Capital, the investment banking division of Barclays Bank Plc. Zenker now says such a transition is unlikely. More new rigs are coming to market, and the economics are not sufficient to lure rigs away from gas. Further, the associated gas content of liquids-rich wells is stacking up more supply.

In a recent update on the gas market, Zenker's group reported that U.S. supply has ratcheted up by 10 billion cubic feet (Bcf) per day from 2007 through 2011, while demand has grown by less than 1 Bcf per day. The gas-rig count has been constant, despite an expected gas price of $12 per million cubic feet calculated to make drillers indifferent to pursuing dry gas or liquids.

At a recent industry gathering in Houston, Pearce Hammond, managing director at Simmons & Co. International, put forth a similar view of gas prices for 2012. When asked when prices would strengthen, he said, "2012 is not that year."

Nearly a quarter of U.S. gas is now produced from shales, where drilling efficiencies are just hitting their stride. Further, companies are at work in the most ideal parts of the plays—the sweet spots—so production will keep climbing. Hammond noted that Devon Energy Corp. indicates its Barnett shale production can be held flat as far out as 2022 with just a dozen rigs.

Shales currently contribute close to 16 Bcf per day to U.S. supply. That contribution also fuels what Hammond expects to be 1.3 Bcf per day of U.S. gas oversupply in 2011, attenuated to only 0.6 Bcf per day of excess supply by midyear 2012. Barclay's most recent update forecasts supply growth of 2.2 Bcf per day in 2012, overwhelming the modest 0.6 Bcf of expected demand increase.

For many companies, the rationale for continued gas drilling is a lack of oil prospects. Also, investors demand production-volume growth, and companies need to drill to hold acreage by production. Finally, associated gas production from the booming oil and liquids-rich plays is on the rise.

Barclays' analysts say completing and connecting gas wells is the only bottleneck holding back supply. That inventory of wells waiting on completion will persist, implying yet more volume waiting in the wings.

"The supply pause we thought might occur in late 2012 may never happen," says Zenker.

Associated gas has been particularly worrisome to Simmons & Co. International analysts. They noted in July 2011 the difficulty of measuring associated gas, as it has been flared in emerging plays like the Eagle Ford, Bakken, and Mississippi Lime, due to lack of infrastructure. Those plays are receiving an influx of midstream attention, introducing yet more gas into the system. Associated gas made up the bulk of the firm’s projected production increase of 1.2 Bcf per day for 2012, up from this year's 62.7 Bcf per day of U.S. dry-gas production.

Barclays' Zenker notes he is often asked whether all this gas will cause a revenue shortfall for producers, driving their cash flow negative and forcing them to reduce drilling. But this isn’t likely in the near future, he says.

"Capital constraints could be a factor, but we don't see that in 2012. Producers are hedged and cash-flow neutral right now," he says.

The only major supply-side surprise has been reduced imports in response to domestic supply growth since 2009. Barclays Capital and Simmons & Co. note Canadian and LNG imports have fallen noticeably through 2011, and both expect the trend to continue.

"We think imports will be near minimums of 700 million cubic feet (MMcf) per day via liquefied natural gas (LNG)," says Zenker, partly driven by prices in North America, and partly by LNG demand in other parts of the world. Simmons' analysts believe 0.9 Bcf per day is the level of imports needed to maintain re-gasification facilities.

The last factor in supply is the amount of gas in storage. Both firms have pegged 2012 storage numbers at close to 4 trillion cubic feet (Tcf). Barclays has revised that forecast to 3.96 Tcf. Simmons suggests that with an oversupply greater than 0.8 Bcf per day, gas could hit maximum storage capacity of 4.15 Tcf in 2012.

The power sector will need to take a growing chunk of the burden of balancing the market in the years ahead.

Counting on demand

Domestic gas oversupply and resulting low prices occurred despite an abnormally cold 2010-2011 winter and an excruciatingly hot 2011 summer throughout much of the U.S. Both weather patterns ameliorated supply and price concerns to some extent.

"Demand has been a hero," said Hammond, noting demand was up 1 Bcf per day in the wake of the Japanese nuclear disaster and re- bounding U.S. petrochemical demand. He forecasts demand will grow to 14 Bcf per day on the back of coal retirements and petrochemical use, but it will take eight years to get there.

Barclays' Zenker doesn't envision any significant demand upside outside of weather patterns. "Weather is about the only big surprise we could get in demand for the foreseeable future," he says. Low gas prices incentivizing additional industrial use could deliver the next-biggest surprise, but he isn't counting on it.

"There isn't a lot of industrial capacity out there ready to absorb gas," he says.

There is, however, regulatory activity that will significantly impact gas demand: the Environmental Protection Agency's Cross-State Air Pollution Rule, slated to go into effect January 1, 2012. The CSAPR, as it is known, requires 27 states to improve air quality by reducing power-generation emissions. The targeted emissions are SO2 and NOX. A further seasonal ozone and NOX reduction kicks in on May 1, 2012. According to the EPA, through CSAPR and other rule implementations power plant SO2 emissions will be cut by 73% and NOX by 54% from 2005 levels.

Zenker says there will be a noticeable impact on coal-fired generation, though the impact of coal-plant retirements will be gradual.

"We do fully expect CSAPR and HAPs-MACTS will result in some coal-plant retirements, but not as much yet in 2012," Zenker says. These are the EPA's Hazardous Pollutants/Maximum Achievable Control Technology rules, a corollary to CSAPR mainly targeting a 91% reduction in mercury releases from coal plants.

The reason for the projected staid near-term impact of this aggressive regulation is that the power facilities most vulnerable to CSAPR are already underutilized. Thus, while the rules won’t result in much incremental gas demand now, Barclays predicts demand could reach 30 gigawatts over the next several years.

"By 2015, this could result in gas demand of 2 Bcf per day, but for next year, just 0.6 Bcf," Zenker says. CSAPR is evolving, so projected results from its implementation vary.

"There is no CSAPR expert. Others have calculated different numbers, and the reality of how utilities operate those plants could vary wildly," he notes. That translates to upside risk.

The final demand question mark is LNG exports from North America. Barclays has already modeled 2 Bcf of LNG export into demand, but not until 2016-2017.

"We could be surprised by a large number of (export) facilities coming online. We pegged the number at two," says Zenker. "The reality is, resource owners could monetize a lot more gas through LNG than expected." However, the firm doesn't believe any projects will achieve first LNG before 2015.

Go long?

How does this wet-blanket prediction square with industry participants advocating aggressive, long-gas stances?

"The reality is there are some people who are more optimistic than we are," notes Zenker. "North of a $5 gas price, a lot of development becomes highly economic. Since 2008, there has been an expectation of rational producer behavior, but that's not how they operate." He also notes some gas plays are economic even at Barclays' low gas-price forecast. And, there is always liquids production, which even some new entrants are pursuing.

"We've seen a dearth of interest from joint venture money in dry gas," Zenker says, noting that all the JV activity is on the liquids side. He believes that $5.50 per Mcf is an equilibrium price at which demand and rate of return are met for most projects. Barclays has advised clients who are long gas to sell forward.

Buyside consultant Energy Solutions Inc. has a less pessimistic view of U.S. oversupply.

In a recent missive, the 15-year-old firm predicted production growth of 1.6 Bcf per day, rather than the 4.5 Bcf per day it forecast for 2011.

This is 0.6 Bcf per day less than Barclays' expectation of 2.2 Bcf per day production growth in 2012, and more bearish than Simmons & Co.'s midyear estimate of 1.2 Bcf per day growth for the same year. Even though many forecasters agree on the upward direction of U.S. natural gas supply, not everyone agrees on the degree.

The price question will come down to producers’ responses, Zenker cautions.

"I'd still point out that the primary driver of prices is how suppliers approach the market."