The federal government’s Energy Information Administration (EIA) reported an in-line decline in natural gas supplies. Stockpiles held in underground storage in the lower 48 states fell by 111 billion cubic feet (Bcf) for the week ended Mar. 5, 2010.

The inventory decline was the 14th in as many weeks. This has finally started to erode the record-high storage amounts, as steady cold weather continued to kick up demand in major gas-consuming regions in the U.S.

Though the heating season officially began on Nov. 1, 2009, net injections continued through Nov. on a national basis. As a result, until recently, gas in storage remained at record high levels.

Continued strong domestic production (from a number of unconventional natural gas fields) and recessionary consumption (due to the economic downturn), particularly in the industrial sector, are at the core of the commodity’s current woes. Stockpiles went on to create new highs last year as the economic downturn ate into demand, and natural-gas producers continued to unlock new supplies from onshore natural-gas fields known as shales.

Months of mild weather further weakened demand for the fuel to heat homes and businesses. As a result, natural gas prices (referring to Henry Hub spot prices) trended down to a 7-year-low level of sub-$2 per million Btu (MMBtu) in Sept. 2009.

However, the ongoing surge in the commodity’s demand has erased a hefty surplus over last year’s inventory level and significantly trimmed the excess over the five-year average level.

As a result of the sustained inventory drawdown, the commodity staged a phenomenal recovery, breaching the $5.70 per MMBtu level during early Feb. 2010. Things appear to be getting better for the natural gas players, with cold weather slowly cleaning up the storage surplus.

The current storage level, at 1.63 trillion cubic feet (Tcf), is down 4.2% from last year’s level but remains slightly above (1.2%) the five-year range (as clear from the following chart from the EIA). Current stocks are 71 Bcf below last year’s level and 19 Bcf above the five-year average.

Note: The shaded area indicates the range between the historical minimum and maximum values for the weekly series from 2005 through 2009.

Source: Form EIA-912, “Weekly Underground Natural Gas Storage Report.” The dashed vertical lines indicate current and year-ago weekly periods.

However, the specter of a continued glut in domestic gas supplies (storage levels remain 1.2% above their five-year average) still exists, and inventories are likely to exit the current heating season very near (or even above) the five-year average.

With winter cold subsiding (cold-weather-demand period ends this month), demand for natural gas for heating and power-plant fuel will reduce. Already, warmer spring weather appears to have arrived in the U.S. Northeast.

Further pressurizing the commodity is the rapid rise in the number of drilling rigs working in the U.S. (natural gas rig count has climbed 39% from a seven-year low reached last July) that signals a production increase later this year in the face of sluggish industrial demand. Meanwhile, supplies from dense rock formations (shale) remain robust.

Given the depressed state of the commodity, the in-line drop in reserves pulled down natural gas prices. In particular, during the last few days, prices have fallen to their lowest levels since late Nov. (currently trading in the range of $4.40 – $4.50 per MMBtu), pressured by milder-than-normal weather at the end of the heating season.

There are concerns among traders that the market will be oversupplied as winter draws to a close, with rig counts going up and industrial demand still struggling due to the weak economy. These factors translate into limited upside for natural gas-weighted companies and related support plays.

Therefore, we maintain our cautious stance on natural gas-focused E&P players such as XTO Energy (XTO), EOG Resources (EOG), Anadarko Petroleum Corp. (APC), Chesapeake Energy (CHK) and Devon Energy Corp. (DVN).

Additionally, we remain skeptical on land drillers such as Nabors Industries (NBR) and Patterson-UTI Energy (PTEN), as well as natural gas-centric service providers such as Halliburton Company (HAL). Although we expect the land rig count to continue with its steady rise during 2010, the large amount of excess capacity in the sector will weigh on dayrates and margins well into the year.

Oil majors like BP Plc (BP) that have significant natural gas operations are also expected to remain under pressure until pricing and demand improve further.

All the above-mentioned companies currently have Zacks #3 Ranks (Hold), meaning that these stocks are expected to perform relatively the same as the overall market during the next 1-3 months. Therefore, investors should maintain their current positions in the stocks over this time period.

Read the full analyst report on “XTO”
Read the full analyst report on “EOG”
Read the full analyst report on “APC”
Read the full analyst report on “CHK”
Read the full analyst report on “DVN”
Read the full analyst report on “NBR”
Read the full analyst report on “PTEN”
Read the full analyst report on “HAL”
Read the full analyst report on “BP”
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