Date Published: 7/17/2009

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Natural Gas Outlook - July 2009
Abstract: Natural gas has seen a significant drop in price recently. Is the drop justified? What could cause natural gas to bounce? Price targets and a fundamental outlook included. Based on this research Hylland Marrket Research establishes a bullish sentiment on natural gas. Companies/ETF's mentioned or related: UNG FCG GAZ

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Previous sentiment:
Hylland Market Research is initiating its coverage for natural gas.

Summary
Hylland Market Research is establishing a bullish sentiment on natural gas for several reasons, which will be discussed in depth within this article: − Increased government involvement in the sector. − Increased concerns on environmental health and 'clean energy'. − Favorable prices compared to other sources of electricity. − Historical seasonal trends indicate July prices offer an advantageous buying opportunity.

Historical Prices
Natural gas has been on a sharp decline for the past 52 weeks. 52 week high: 13.793 52 week low: 3.337 -78% YTD (Nymex Natural Gas Continuous Contract)

Fundamentals
Natural gas prices have been hit hard by an increase in reserves and a decline in consumption. Using the latest storage numbers from the EIA (Energy Information Association), the amount of natural gas in storage has increased to 2,796 Bcf (Billion cublic feet), which represents a 19.3 percent increase from the 5 year average.

The total consumption of natural gas in the U.S has seen a decline of about 4.2% compared to last year. And is projected by the EIA to decrease 2.3% YoY (Year over Year) in 2009, and remain steady at that level through 2010. In response to the fall in natural gas prices, drilling companies have cut back in their production, cutting production from 57 percent of their rigs compared to September 2008 according to the EIA. And rightfully so, many companies can not even make a profit with natural gas below $4. From information filed in Southwestern Energy Company's 8-k quarterly report in March we can get an idea on what the production costs are for major natural gas companies.

Company Southwestern Energy Company Noble Energy Chesapeake Energy Ultra Petroleum EOG Resources EnCana Range Resources Pioneer Natural Resources Devon Energy XTO Energy Newfield Exploration Forest Oil Cimarex Energy Cabot Oil & Gas Anadarko Petroleum Apache Quicksilver Resources St. Mary Land & Exploration Swift Energy Denbury Resources

Lifting Cost Drillbit F&D Cost Production Costs Production Costs (per Mcfe) (per Mcfe) $2.21 $3.09 $3.17 $0.88 $4.09 $5.21 $5.35 $1.12 $6.18 $7.34 $7.54 $1.16 $0.75 $1.92 $1.97 $1.17 $2.10 $3.29 $3.38 $1.19 $2.12 $3.35 $3.44 $1.23 $1.89 $3.13 $3.21 $1.24 $4.41 $5.78 $5.94 $1.37 $2.44 $3.97 $4.08 $1.53 $1.67 $3.21 $3.30 $1.54 $3.08 $4.68 $4.81 $1.60 $3.66 $5.29 $5.43 $1.63 $4.42 $6.15 $6.32 $1.73 $1.99 $3.74 $3.84 $1.75 $6.09 $7.86 $8.07 $1.77 $2.53 $4.31 $4.43 $1.78 $1.15 $2.99 $3.07 $1.84 $4.30 $6.17 $6.34 $1.87 $6.08 $7.96 $8.17 $1.88 $2.92 $5.48 $5.63 $2.56 (per Mcfe) (per Mmbtu)

The conversion from production costs per Mcfe (thousand cubic foot) to MMbtu (Million BTU) was done by the conversion 1Mcfe = 1.027 MMbtu. The data supplied by Southwestern Energy Company is a three year average of production costs for these listed companies. It is apparent that many of the prominent natural gas producers simply can not make money with natural gas at its current price levels. Hylland Market Research expects production to continue to decline until prices rebound. As shown by the EIA, as of May 2009, production is off 57 percent from a year ago, and it is easy to imagine production has continued to decrease as prices have declined further since May. Hylland Market Research believes that consumption will be sparked once again for several fundamental reasons. Natural gas is much more efficient than other sources of electricity such as coal, for that reasons we are now seeing the federal government use natural gas to push its 'green' agenda. Recently we have seen the senate pass two key pieces of legislation: The Natural Gas act of 2009, which adds numerous tax credits for the purchasing of natural gas vehicles, creates an incentive for dealers to sell natural gas vehicles and requires that 50% of the federal government vehicles be run on natural gas in the next 5 years. There is also the new “Cap and Trade” bill, which aims to cut CO2 emissions by placing a “cap” on the amount CO2 a company can create. If they want to emit more CO2, they must buy permits to do so. This bill alone has the potential to stimulate the use of natural gas because natural gas emits roughly half the CO2 compared to coal. Although the intent of the bill is to move our electrical sources to wind, solar and other 'green' sources, that will not happen immediately. Before the green energy sources are integrated, coal plants will be phased out and replaced with their natural gas counterparts.

Both of these pieces of legislation are going to stimulate the use of natural gas whether they “succeed” or not. The last effort of this magnitude by our federal government on energy reform was in Ethanol. Even though the idea was a bad one (many will argue that it failed), the price of corn jumped nearly 400% from its 2005 lows. Just how much more demand will we see in natural gas? The EIA offers one projection that does not even factor in these 2 bills discussed above. In its report titled “The Implications of Lower Natural Gas Prices for Electric Generators in the Southeast” the EIA projects:
“a decline in the average delivered natural gas price from $4.75 to $4.25 per MMBtu ...could boost natural gas consumption for baseload electricity generation in the electric power sector by about 2.1 billion cubic feet per day (Bcf/d) in the ESC (East South Central) and SA (South Atlantic) combined.”

To put that increase in perspective, The combined regions (East South Central including Alabama, Mississippi, Tennessee, and Kentucky and the South Atlantic including West Virginia, Virginia, Delaware, Maryland, North and South Carolina, Georgia and Florida) consume an average of 10.5 billion cubic feet per day of natural gas per day. The projected increase is a 20% increase in natural gas consumption for the region! Now, natural gas has fallen much further than $4.25 per MMbtu, to as low as $3.75 in the Southeast, and yet the majority of traders are still betting on natural gas consumption to decline. On top of all of this, the Department of Energy projects that an additional 259 Gigawatts of electricity generation will be needed by 2030. To generate the new electricity, producers will have several choices to choose from: -Coal, which costs about $2.19 per million btu at current prices. Coal energy currently costs about $.0074 per kWh to produce assuming it is coming from a more efficient than the average coal plant. This cost does not include increased charges due to CO2 emissions. -Natural gas, which costs about $3.25 per million btu at current prices. Costs about $.011 per kWh to produce. -Wind or solar, which will undoubtedly see increased utilization, but still can not produce electricity at comparable rates. According to Solarbuzz.com Solar energy costs about $.204 per kWh (not including tax credits) to produce, and according to the American Wind Energy Association wind energy comes in at $.05 per kWh after factoring in tax credits. The choice for cheap power is still between coal and natural gas. At first glance it seems coal is an easy choice, however that is not the case when you factor in Cap and Trade (natural gas emits half the CO2 of coal) and the increased cost of coal plants compared to natural gas. Factoring in the additional costs involved with coal, natural gas seems to be the winner. This has already become apparent to many power producers. The EIA reports in its annual energy outlook that, of the plants in the planning stages right now, 53% are to be natural gas power plants. It appears that natural gas is being set up to be the future energy source of America.

Historical Prices and Trends

Natural gas bears cite the unprecedented supply of natural gas in storage and general state of the economy as reasons to be pessimistic on the price of natural gas. And they have been right, natural gas has fallen 78%. But how have past prices behaved after similar fundamentals? Most recently, two years ago, in July 2007, natural gas in storage was at a 5 year high and prices fell to around $6.75 per MMbtu. By November 2007 prices had risen above $8.00 per MMbtu, a 15% increase in 4 months. In fact, looking back at historical prices the last 20 years, buying natural gas in July and selling in November would have been a profitable trade 14 of those years, flat 2 of those years and a losing investment in only 4 of those years. Hylland Market Research believes that a decline in natural gas prices from $12+ was needed, and was well justified based on the fundamentals. However, as apparent in a majority of the last 20 years, we believe traders have overreacted (as usual on Wall Street) to the latest data, and pushed natural gas prices too low. It seems that it may be a regular occurrence on Wall Street for natural gas traders to become too bearish on natural gas during this time period with headlines of increased storage that are typical in the summer months.

How to Invest in Natural Gas
An investor has several choices to make when looking to invest in natural gas. One can invest in the futures if able. But for the average retail investor there are also several ETF's that follow natural gas. The largest is UNG, The United States Natural Gas Fund, which recently has come under the eye of regulators at the SEC because of its size. Currently, UNG is trading at a premium because they have stopped issuing new shares as ordered by the SEC. This creates an interesting scenario for potential investors. UNG is looking to create 1 billion more shares, which once released will cause the premium in the ETF's price to disappear, lowering the price. However, if natural gas starts to move up before the SEC allows UNG to issue more shares, the price is likely to outperform natural gas futures because of the lack of shares of UNG available. UNG offers high volume, 30 million+ shares traded daily, and active options as well. GAZ is another ETF that aims to mirror natural gas futures just like UNG does. It trades significantly less volume than UNG and does not have options. The other route for an investor to go is investing in natural gas companies rather than the commodity. There are thousands of individual companies that an investor could buy. The list on page 3 provides a good initial list along with an idea on each companies profit margins. There is also an ETF that offers exposure to a large group of natural gas companies. FCG does not invest in natural gas futures, but instead common stock of natural gas companies. In order to decide how to invest in natural gas, an investor needs to determine their investment goals. Investing in natural has futures, or an ETF like UNG can be a long term investment, but the spot price of natural gas is more volatile than an investor may want. An investment in a specific natural gas company may provide a dividend depending on the company, and big companies may offer more diversification by also being involved in other energy sources, exploration, etc. However, you also get the risks of having to all your 'eggs in one basket' and would lose your whole investment if that specific company were to go under. An ETF like FCG will likely follow the general stock market as much as the price of natural

gas, and will not be as volatile, but may be a better long term investment in natural gas as over time, more expensive natural gas means higher profits for natural gas companies.

Price Targets
Hylland Market Research expects natural gas prices to rebound to $4 by the end of 2009 as long as the world economy stabilizes as projected. We believe that many traders are not accurately accounting for the increased demand that will occur in natural gas over the next several years. Hylland Market Research projects an increase in world natural gas consumption that is greater than the EIA projects. Because of the low prices currently and decreased production, Hylland Market Research recommends investents in natural gas through investments through futures, or ETF's such as UNG rather than companies at the current time. Look for our coverage of individual natural gas companies for information on when we project these companies to become attractive buying opportunities.

Sources The EIA reports cited can be found here: http://www.eia.doe.gov/oil_gas/natural_gas/info_glance/natural_gas.html http://www.eia.doe.gov/emeu/steo/pub/special/2009_sp_02.html http://www.eia.doe.gov/oiaf/aeo/index.html and Southwestern Energy Company's SEC filing can be found here: http://www.secinfo.com/d75b.s7.d.htm
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