Although sky-high oil prices are generating much exuberance in the oilpatch, a much quieter party is underway among natural gas producers.

Flush from a run-up in gas prices — which had soared to a 29-month intraday high of US$12.76 per million British thermal units by early June — gas producers are paying off debt and planning to drill new wells.

Indeed, natural gas futures have more than doubled after sinking to US$5.30 per mmBtu on the New York Mercantile Exchange in the summer of 2007, when day deals for gas from reserves in the U.S. Rockies plummeted to mere pennies on ample supply and flat demand.

But now, prices for natural gas and its supercooled twin, liquefied natural gas, have became more closely linked. Canadian production has continued to drop, and demand for clean-burning fuel has continued to grow. A cold winter drew down storage levels more than expected and the market has grown anxious about storage levels being adequate to meet next winter’s demand.

So, the short-term future looks bright for natural gas — but only if supplies of LNG don’t increase, experts say. “Six months ago, nobody saw how tight the LNG market would become,” says analyst Martin King with FirstEnergy Capital Corp. in Calgary. “The more you pull back on LNG, the more price strength will remain. The question is: what will happen if there’s more LNG in the market?”

Competition for LNG became heated after an unexpected outage at Japan’s main nuclear power station forced that country to rely heavily on LNG imports, a trend that will continue into May 2009. Spain also has bumped up its LNG imports to offset low reservoir levels in its massive but drought-stricken hydroelectric dams.

King says FirstEnergy is bearish because of the aggressive supply response from U.S. producers, which have pumped up production from multiple sources by 2.5 billion cubic feet a day over the past year. There’s more gas expected from the Rockies, where additional pipelines to relieve bottlenecks are planned. Increased production is also anticipated from unconventional sources, including shale deposits and “tight” gas, which comes from deposits found in hard rock such as limestone that are particularly resistant to extraction.

Canadian natural gas volumes, produced primarily in the West, have dropped by about 1.1 bcf a day, by contrast, due to low prices, high costs and the threat of an increase in royalty rates in Alberta.

“It’s not clear how much more of a bang producers will get,” King cautions. “So, it’s tough to say how much more gung-ho to get.”

The wild card, as always, is the weather.

FirstEnergy predicts 2008 natural gas futures will average US$9.75 per mmBtu on the NYMEX, with spot deals at AECO, Canada’s benchmark trading hub for natural gas, at $9 per gigajoule. For 2009, King predicts slightly softer prices, to US$9.50 mmBtu on the NYMEX, with spot deals at AECO remaining at $9 per GJ.

To describe the situation for Canadian natural gas producers as being tough in the past couple of years would be an understatement. After flooding the market in response to a supply crunch created by demand and natural disasters such as hurricane Rita in 2005, producers in Western Canada have been hit by a triple play of low prices, a strong Canadian dollar and the threat of higher royalty payments in Alberta.

The number of wells drilled across Canada dropped by about 21% in 2007 to 18,557, from a high of 23,500 in 2006, according to the Petroleum Services Association of Canada. The number of wells drilled was expected to slide even lower this year, to 16,500, as companies slash their budgets and redirect funds to oil. But the recent cold winter in North America and soaring crude oil prices have made natural gas more attractive, with the result that an additional 2,000 wells are expected to be drilled in 2008.

“We don’t think the fundamentals have changed, year-over-year,” says Bill Gwozd, vice president of gas services with Ziff Energy Group in Calgary. “To us, the two big factors influencing the price pendulum are growth demand from power generation and declining production in Western Canada.”

North America wants to go green on generation, but the emergence of so-called “clean” coal power plants and nuclear power stations are decades down the road. “Natural gas is the only short-term player in town,” Gwozd says.

@page_break@But there is a concern that low demand in Europe could result in more supplies of LNG being routed to North America, which has three times the storage capacity, at four trillion cubic feet. “It’s bad news for us to import LNG in the summer,” Gwozd says, “because it competes with natural gas for storage.”

CIBC World Markets Inc. analyst Jeff Rubin is more bullish than other analysts on natural gas prospects, boosting his early predicted average of US$9.50 per mmBtu to US$12.50 per mmBtu in 2008 and US$14 per mmBtu in 2009.

He also calls natural gas the “sweetheart” of the power-generation sector. “Outside of a few isolated places such as Alberta, there is no new coal generation being licensed in North America,” Rubin states in a recent report. “Virtually all of the increase in power capacity over the next decade will be gas-fired, sending North American gas prices well into the teens over the next several years.”

But an even more influential effect on pricing has been the failure of LNG to make its way to North America, the report says, as it is pulled instead to other, more lucrative shores in Asia and Europe.

The impact has been felt sharply in North America; the U.S. imported approximately 0.8 bcf per day during the first quarter of 2008, compared with 1.9 bcf per day in the same period a year prior, according to LNG maven Stacy Nieuwoudt at Houston-based Tudor Pickering Holt & Co. Securities Inc. In June, imports averaged one bcf per day, down from 2.8 bcf per day a year before, because of the higher bids from energy-strapped Asia and Europe.

The higher prices are a result of Japan and Spain basing their bids on oil, while North American markets price their LNG according to domestic natural gas supply. “When you have consuming countries purchasing LNG at crude oil-linked prices, that raises the overall LNG price in the market,” says Mark Leggett, an oil and gas analyst with Bank of Montreal in Calgary. “And that will have an impact on the North American natural gas market as well.”

Leggett sees natural gas averaging US$9 per mmBtu in 2008, rising to US$11.43 per mmBtu on the NYMEX in 2009, reflecting strong residual oil prices and less of a storage cushion going into the coming winter heating season. This past winter lasted longer and the cold temperatures were closer to normal than the two previous mild winters. The prolonged colder weather saw storage being drawn down by about 20% more than in the winter of 2006-07, and still by about 4% more than the five-year average.

According to the National Energy Board, storage inventories are expected to refill to around 95% of last year’s peak of 4.1 trillion cubic feet, or slightly more than 3.9 tcf. “The profile of injections could be affected if the summer is particularly hot,” the federal energy watchdog states in its summer outlook for Canadian energy.

The NEB predicts prices will remain between $US11 per mmBtu and US$13 per mmBtu this summer. The board fully expects that strong supply growth from the U.S. will be more than adequate to meet storage expectations for the coming winter heating season. IE