Agustino Fontevecchia, Forbes.com

The boom in natural gas production that has pushed prices below $2 per thousand cubic feet back in April has planted the seed for a huge correction the other way.  As gas-directed exploration & production has fallen materially and the large storage surplus flips on gas-fired power demand, prices are set to rebound strongly, hitting $4 by the end of the year and possibly breaking higher, according to Canaccord Genuity.

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While there are many moving parts, natural gas prices are strongly tied to fundamentals.  And these suggest prices will keep on climbing.  The April bottom occurred as a storage surplus was growing large, which in turn sparked robust demand for gas-fired power as utilities moved away from expensive coal.  The “correction mechanism,” as Canaccord’s John Gerdes put it, went into overdrive as prices surged on the back of buoyant demand; demand is now waning, though, as prices rise.

As cheap natural gas and intense demand from utilities drew down inventories, gas producers were cutting their production in response to ultra-low prices.  “Gas directed drilling has overcorrected to the downside against the backdrop of extraordinarily weak gas prices,” explained Gerdes, noting the E&P industry “has cut gas-directed activity to [about] 450 rigs, which is markedly below the 650-675 gas rigs necessary to maintain long-term market balance.”  The market, the analyst explains, is undersupplied by 1.5 to 2 billion cubic feet per day in a weather-normalized basis.

According to their estimates gas storage will hit year-ago levels toward the end of this year, with inventories peaking around 4,000 billion cubic feet and then falling dramatically.  “If the storage dynamics materialize as [forecasted], our $4 gas price forecast next year has upside basis,” wrote the analyst.

Inventories could fall to about 1,750 billion cubic feet by April 2013, then bounce back up to 3,500 Bcf by November 2013, “a level comparable to November ’08.  Notably, in the fall of ’08, natural gas prices were above $7.”

At the same time, supply is expected to remain stable through mid-2013, with modest gains in early 2013 given the completion of wells deferred earlier this year.  An overly optimistic estimate of about 600 gas rigs by November 2013 would result in a gas storage level of 3,500 billion cubic feet.  “Without at least a $4 gas price signal and corresponding increase in gas-directed drilling activity, our November ’13 storage projection will likely also prove to be overly optimistic,” Gerdes added.

These factors suggest natural gas prices are ready to move up once again, despite a recent correction.  Ben Bernanke’s QE3 announcement could add fuel to the fire.  Gerdes suggest the top pick in the sector is Cabot Oil & Gas, which has 10% potential upside in a $4 gas environment and 60% upside assuming his long-term $4 gas expectation.  Other companies that could benefit include Chesapeake Energy, Apache Corp, ConocoPhillips, and Exxon Mobil.

Supply and demand dynamics suggest the stage is set for rising natural gas prices.  With storage levels falling and robust demand (which is weakening) putting a floor under prices, natural gas could rally to $4 by the end of the year, if not higher, Canaccord’s Gerdes believes.  Loose monetary policy and the coming winter could provide further price catalysts to bet on the rise of natural gas.