The challenge the natural gas industry faces now is what happens to gas demand if gas prices remain historically low? At the present time, we are in the “shoulder” months of the year when natural gas demand is traditionally low due to the lack of heating or air conditioning loads as temperatures are moderate. The economic recovery remains sluggish so the natural gas market is getting little help from increased industrial use of gas, despite very low prices. The greatest positive for the natural gas industry is the increased demand emanating from the electric power generation market, which is coming at the expense of coal consumption. There are various estimates about how much incremental natural gas is being consumed as a result of this price advantage. The best estimates we have seen suggest that the demand increase centers around 5-6 billion cubic feet per day (Bcf/d). That volume represents approximately 7% to 9% of the 67.78 Bcf/d of natural gas produced in February in the Lower 48 States as reported by the EIA.

Last year, natural gas accounted for nearly 25% of the nation's electric generation versus just over 42% for coal. When we examine the latest monthly data, it is clear the natural gas is still gaining market share at the expense of coal. That gain can be seen in the chart of the latest monthly data in Exhibit 8 (Prior page).

Expectations are that natural gas will continue to gain market share in electricity generation this year merely because its price is so low. Coal prices have been undercut by low gas prices but eventually we expect coal will win back some of the lost demand, especially when the economic recovery accelerates. Until then, low coal and natural gas prices will continue to battle, with gas being helped by the recently tightened Environmental Protection Agency (EPA) rules on emissions from coal-fired power plants. We attended a presentation by an energy consultant who worked for many years for American Electric Power (AEP-NYSE) that is the nation's largest operator of coal-fired power plants. As one would expect, many of these plants are old, although they continue to function well. Most of the focus on the new EPA emission rules dealt with their application to new generation sources, meaning they are applied to newly constructed plants. However, when existing plants experience equipment-related downtime, the repairs and modifications can cause the plant to become subject to “new source” reviews and thus, these “new source” emission standards. According to the presenter, his former AEP colleagues suggested to him that they had established a $5 million threshold for capital investments that would determine whether the plant would be shut down rather than repaired. The presenter commented that he could not think of any significant part of a coal-fired power plant that wouldn't exceed this threshold when, and if, critical equipment broke. In his view, America will experience faster erosion in coal-fired power generation capacity than expected by either regulators or company managements. For that reason, he was positive about the longer term outlook for natural gas demand, meaning he also sees higher gas prices down the road.

Eoin Treacy's view The coal/natural gas ratio has hit at least a near-term and probably a medium-term peak following an accelerated advance. This suggests that natural gas's underperformance relative to coal has ended at least for the time being. In absolute terms, natural gas prices have posted their largest rally in almost a year, from a deeply depressed area. They will need to hold the majority of the advance on the next pullback if a medium-term low is to be confirmed.

There is still a great deal of variability in the performance of shares in the natural gas sector. However EnCana is noteworthy. It has rallied impressively from the lower side of the developing base and a clear downward dynamic would now be required to check potential for additional upside. Rex Energy is a considerably smaller company but is also rallying from the lower of a lengthy range. EOG Resources has pulled back from the upper side of its two-year range to test the $100 area where it appears to have found support. A sustained move below $100 would be required to question potential for some higher to lateral ranging.