[Editor’s Note: We think there’s enormous opportunity to be had in natural gas in the coming years, but it’s important to know the ins and outs before investing. In this is two-part series, StreetAuthority’s David Sterman will discuss the current situation with natural gas, when he thinks it will be “time to buy,” and three of his favorite ways to profit. The following article is Part 1 of our series.]
 
Place the number 725 in your mind. In a few moments, I’ll explain why it’s the figure that could finally spell the end of the  natural gas industry’s troubles. The good news: 725 will soon approach, and that’s when it will be time to buy into this sector.

By now, you’ve read countless articles about the rise and fall of the natural gas industry. A half decade ago, the industry was giddy with delight because a newly-refined drilling technique (hydraulic fracturing, known as “fracking”) turned seemingly dormant energy fields into absolute gushers. As company after company announced promising drilling results — and the ensuing robust spending plans — few realized that the basic laws of supply and demand would soon be violated.

And those laws are unbreakable.

In the middle of the last decade, gas wells weren’t all that productive, and the industry put an increasing number of wells in service just to find enough gas to meet our nation’s needs. In fact, the natural-gas rig count, as tracked by energy firm Baker Hughes (NYSE: BHI), spiked from 966 at the end of 2003 to around 1,450 by the end of 2007.

 
By the middle of 2008, the price of natural gas spiked to $13 per MCF (thousand cubic feet) as supply only slowly started to catch up to demand. Yet by end of that year, gas would be back down to $5 MCF. Many thought that was due to the slow U.S. economy, but few realized that the industry was creating a nightmare scenario as newly-productive gas rigs threatened to create a glut of natural gas that simply couldn’t be absorbed by demand.

At the time, the industry simply assumed that older, less-productive wells would peter out and supply would eventually drop. Indeed, the number of wells in service dropped by a whopping 43% in 2009 to just 759 — the lowest figure in more than a decade.

Please, make it stop
Even with fewer rigs pumping out gas, few understood the depth of the problem. Assumptions that industry output would naturally decline led many gas drillers to conclude that it was time to put more rigs back in service to help maintain output. So the rig count rose 21% in 2010 to 919. As supply of gas eventually overwhelmed demand, prices utterly collapsed, recently falling below $3 per MCF.

The key factor that everyone underestimated: fracked wells are so much more productive than traditional wells, and they last a lot longer than most expected, so a simple correlation between rigs in service and industry output no longer held. Consider this data point from Pritchard Capital Partners: The number of rigs tapping into the Barnett Shale (in Texas) fell from 88 in October 2010 to 56 in October 2011. Yet output in the Barnett Shale actually rose from 5.4 billion cubic feet (BCF) per day to 5.7 BCF. This means each well remaining in service was 40% more productive than each well taken off-line.

Yet the long nightmare for this industry should soon end, for a very prosaic reason. Recall the number 725 I mentioned at the start of this article. That’s the rig count needed to bring down production to where supply falls to demand levels. It’s a far cry from 992, the number of gas rigs that were in service back in the summer of 2010. Now look where that figure stands.

As of Jan. 27, 2012, the weekly natural-gas rig count stood at just 777. And it’s about to drop even more. Industry leader Chesapeake Energy (NYSE: CHK) announced it is taking 23 rigs out of service. These are healthy, productive rigs. At first blush, this would seem to be a foolhardy move, but it’s actually simple Game Theory. Chesapeake is counting on many of its peers to also bite the bullet. Common sense dictates that a reduction in gas output would fuel a spike in prices, putting all players ahead in terms of realized prices.

Chesapeake’s peers, EXCO Resources (NYSE: CXO) and Encana (NYSE: ECA), have also recently announced plans to take drilling rigs offline. Let’s assume that Chesapeake’s other peers never took the Game Theory course in college, and keep pumping away. Output of gas will still fall, as these players are at least wise enough to stop putting new wells into service. Simply put, it’s almost impossible to make profits when spot prices fall below $3.

As a result, the existing wells will slowly see falling output as each quarter passes. Despite the unexpected robust initial output noted in places like the Barnett Shale example earlier, the depletion of wells is one of the immutable laws of physics when it comes to energy drilling.

The fact that natural gas prices remain in a deep funk, despite rig count starting to come down quickly, is simply evidence of a lagging indicator. The current crop of rigs is remarkably productive, so output isn’t falling nearly as fast.

But it’s only a matter of time.

The investment community cares only about one thing: Natural gas stocks will be a bargain only when industry output falls below demand and the stunning amount of natural gas in storage starts to be worked off. Analysts at JP Morgan think the natural-gas rig count will need to fall closer to that 725 mark (from a current 777) for supply to drop far off. We’ll may even have to do even better than that, thanks to a very mild winter that has reduced demand for gas.

Consider this graphic from the U.S. Energy Information Administration (EIA)

 
The red line tells you that we’re at the high end historical range in terms of seasonal storage figures.

Time to buy?
There are two schools of thought about when investors will pile in to natural gas stocks. Most Wall Street analysts will upgrade their ratings when the industry storage levels start to come down and natural gas prices move handily above the $3 pre MCF mark and toward the $4 mark.

But another school of thought suggests it’s always best to buy into an industry a few quarters before the dynamics start to improve. In effect, if you wait for a tangible turn, you will have missed it.

I’m of another mind. Call it the “third school of thought.” Why not split the difference?

• Watch the rig count and trace its trajectory to that all-important 725 rig count.

• See whether competitors respond to Chesapeake’s bold move to cut capacity.

• Monitor Washington’s discussions about potential legislation in support of natural gas-powered vehicles.
 
• Track what the IEA has to say about gas in storage. If gas in storage begins to drop at a more robust pace, then natural gas traders will start to take note.

Action to Take –> You can’t wait for these sign posts to shift from red to green. By then, it will be too late. Instead, you need to see them start to move.

For example, I’d be a buyer of naturalgas stocks when the rig count is at 725, regardless of what spot prices indicate. Or I’d be a buyer if storage levels sharply dropped, even if the underlying price of natural gas failed to respond initially.

In part two of this piece, I will look at three natural gas investment ideas that represent a distinct set of risks and rewards.

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