Steep contango points to sharp rebound in natural gas

By Moming Zhou, MarketWatch

NEW YORK (MarketWatch) -- Futures contracts suggest natural-gas, the worst performing major commodity this year, could see a big rebound when winter demand picks up later this year, putting pressure on producers which have sharply cut back on exploration.

On the New York Mercantile Exchange, natural gas for July delivery currently trades at about $3.80 per million British thermal units. But contracts for delivery at the end of December are trading more than 60% higher, at above $6. Futures contracts for delivery in 2010 also trade above $6.

The situation where the price of a commodity for future delivery is higher than for nearby contracts is called contango.

"The contango is the steepest I can recall," said John Killduff, an analyst at MF Global. "Natural gas could easily surpass $6 in the winter."

Should such scenarios play out, winter natural-gas prices could approach, or even surpass $7, if investors keep pushing up winter contracts in the following months, analysts said.

For consumers, rising natural gas is likely to put new restraints on their spending, coming at a time when the U.S. economy is in need of a consumption boost to climb out of the recession.

But for investors who have bought natural gas futures or exchange-traded funds such as the United States Natural Gas Fund /quotes/comstock/13*!ung/quotes/nls/ung (UNG 13.92, -0.12, -0.86%) , gains might finally be in sight after steep losses since the summer of last year.

A sharp contango encourages investors and producers to store natural gas and wait for a higher price in the winter, which could further dampen spot prices and make the contango even steeper.

The current contango in natural gas is reminiscent of the "super contango" in crude-oil futures that occurred about half a year ago. At that time, crude contango helped push inventories at Cushing, Okla., the delivery point for Nymex crude futures, to a record high. See related story.

Crude has since rallied more than 50%, while Cushing inventories have slumped 14% from their peak.

Fewer rigs

The rebound in natural gas prices is widely expected partly because producers have sharply cut back their gas exploration over the past few months, discouraged by a 70% slump in prices from highs above $13.50 back in July of last year.

"Low natural gas prices brought about by the current economic slump have had a dramatic impact on recent drilling activity," the Energy Information Administration said in its monthly report.

The number of natural-gas rigs to drill wells slumped to 700 in the U.S. in the week ended June 5, the lowest level since late 2002, according to Baker Hughes Inc. /quotes/comstock/13*!bhi/quotes/nls/bhi (BHI 40.65, +1.01, +2.55%) , a consultancy for the oil and gas industry.

That's a sharp drop from the record high above 1,600 hit in last August.