Highlights include Nabors Industries Ltd. (NBR), Patterson-UTI Energy, Inc. (PTEN), BJ Services Co. (BJS), EnCana Corp. (ECA), EOG Resources, Inc. (EOG) and Chesapeake Enery Corp. (CHK).

Growing optimism about the economic outlook has pushed the equity markets significantly higher from the March 2009 lows. Crude oil and most of the other commodities have been active participants in the rally.

As this first chart shows, natural gas has largely been absent from this rally. In fact, natural gas prices have been particularly weak in the last couple of days, erasing the gains made in the preceding three weeks and pushing the commodity back under the $4 level. ?



Blue line: Oil; Red line: Natural Gas (Source: wsj.com)

This decoupling of natural gas prices from other commodities in general and crude oil in particular is rooted in natural gas' peculiar supply-demand fundamentals. As we explain below, this trend is expected to remain in place over the coming months, even as confidence in the economic outlook further improves.

This has major sub-sector and stock selection implications. In the oil and natural gas sector, we would prefer to own "oily" names over "gassy" names -- service players with more of an international rather than U.S. focus, and deepwater rather than onshore U.S drilling exposure.

We remain wary of natural gas centric oilfield service players, though they have been beneficiaries of the ongoing rally. Plenty of drilling and pressure pumping capacity was added in the last cycle, which will keep dayrates and margins under pressure at least through 2010, way after the rig count has stopped falling.

As such, we see no justification for the recent strong gains made by Nabors (NBR) and the Patterson-UTI (PTEN), major land drillers in the U.S. We would also avoid BJ Services (BJS), one of the largest pure-play pressure pumping players.

Among exploration and production (E&P) players, we prefer to own companies with exposure to the shale plays and attractive hedge positions. Companies like EnCana (ECA), EOG (EOG), and Chesapeake (CHK) would fall in that category.

While natural gas' demand side should benefit from the improving economic outlook, particularly demand from industrial consumers, it is the supply side of the equation that, in our view, will keep pricing gains in check. For our near- to medium-term supply needs, there is plenty of natural gas in storage.

The Energy Information Administration (EIA) reported yesterday that current storage levels are 32% above the year-earlier level, and more than 22% above the 5-year average. As the following chart from the EIA shows, current storage levels are close to the top end of the historical range.



The outlook for domestic natural gas production is as good as it has been in decades. This is due to the discovery of prolific shale gas fields in the last few years and the refinement of more efficient drilling and completion techniques. The significant drop in the rig count from the late-summer 2008 all-time high (it has already dropped by more than 50%) is expected to moderate production growth rates.

But with the credit markets coming back to some level of normalcy, it would not take long for the growth momentum to resume. Oilfield cost deflation and the emergence of these shale plays has brought down the breakeven natural gas price required by exploration and production (E&P) players.