One of the starkest trading themes in the 2010 energy markets was crude oil futures' outperformance relative to natural gas. Front-month WTI gained 6% in the first 11 months of the year, while Henry Hub prices fell 24%. While U.S. gas has been trading below BTU parity versus oil for the past five years, the ratio now stands at a record differential, with oil priced more than 23 times higher than gas.

As might be expected, a similar disparity occurred in oil and gas equities during 2010. Companies whose earnings are more leveraged to oil prices outperformed those whose earnings derive more from gas prices.

Shares of oil-leveraged producers gained an average of 9% in the first 11 months, while natural gas producers declined 15%. The E&Ps that shifted focus toward shale oil or natural gas liquids fared better than those whose production profiles remained focused on North American dry gas.

Price outlook

Most analysts are bullish, or at least constructive, on global oil prices for 2011 and beyond due to strong demand from non-OECD countries and weak output from non-OPEC producers. But the outlook for North American natural gas is overwhelmingly pessimistic for the next several years. Inventories remain well above historical averages despite a hot summer and cold winter in 2010. And gas supply continues to grow as companies accelerate drilling even at $4 to $5 prices, making their activities barely economic.

Moreover, demand for natural gas has been historically inelastic; cheap prices tend not to spur demand. Within the past three months, 21 out of 46 contributing Thomson Reuters I/B/E/S analysts have lowered their 2011 forecasts for natural gas prices. And they are placing more "Buy" recommendations on oil-weighted equities and more "Sell" ratings on those exposed to gas.

Despite this negative outlook for natural gas futures and associated stocks, a flurry of corporate deals occurred in the natural gas market this past year--and at premium prices. Industry-leader ExxonMobil initiated the activity with its $41-billion acquisition of gas producer XTO Energy.

While none of the subsequent deals came close in size, several other super-majors also significantly increased their exposure to North American natural gas, either by purchasing other gas producers directly or via shale-acreage purchases or joint ventures.

Europe's largest energy company, Royal Dutch Shell Plc, in May bought most of natural gas-focused E&P East Resources Inc. for $4.7 billion. France's Total SA made a $2.25-billion purchase of some of Chesapeake Energy's U.S. shale operations. Most recently, U.S. giant Chevron paid $4.2 billion to buy natural gas producer Atlas Energy. Also, several major players from Asia, notably Reliance Energy of India, have entered the U.S. natural gas market with large cash injections, especially for joint ventures in the Eagle Ford shale.

Capital Inflows

There appears to be a dichotomy between corporate managements' strategies and the investment community's expectations regarding North American natural gas. The former seem focused on long-term production growth, while the latter is more concerned with near-term return on capital employed and free cash flow.

However, during third-quarter 2010, Thomson Reuters Lipper data showed capital inflows to some of the independent E&Ps with the most gas exposure after seeing outflows for the prior two quarters. The third-quarter investments were made on behalf of long-term, value-oriented institutions and some beta-driven hedge funds that typically have not maintained broad-based exposure to the energy markets.

The stock-specific selection in the E&Ps with exposure to the lowest-cost shale-gas resources reflects the expectation that M&A activity will continue into 2011. With already large, diverse and mature asset bases, integrated and international oil companies are struggling to find growth opportunities that can meaningfully contribute to their production expansion. And the size of the North American shale-gas resource base is material enough to fit that bill.

At the same time, there are a lot of relatively small companies operating across a wide variety of shale resources that will need to respond to weak natural gas prices, assuming prices remain depressed. Given these prospects for consolidation, capital inflows to gassy E&Ps should continue.

But what about the long-term fundamental outlook for gas? On election day 2008, when Barack Obama won the presidency and Democrats acquired a majority in both houses of Congress, front-month natural gas futures spiked 6%. There was no fundamental basis for this price action--the commodity was instead supported by the gains in the broader equity indices and in crude oil prices that day.

Traders also attributed the climb in natural gas futures to the Democrats' clean-energy agenda, theorizing that the new administration would support policies to incentivize use of the commodity for power and/or transportation. So far this notion has failed to pan out, however, leaving many industry participants frustrated that the administration has lent more support to renewables than to relatively clean-burning natural gas.

With carbon-emissions legislation off the agenda, coupled with the ongoing increases in coal-fired power-generation capacity, the prospects for industrial power demand for natural gas do not look bright for the near and medium terms. Despite some coal-to-gas switching by power plants throughout the year, some analysts think that natural gas prices will have to fall further and stay low throughout 2011 to encourage enough coal substitution to dent supply and stimulate secular demand growth.

As for transportation demand, the Natural Gas Act, which proposed incentives for purchasing natural-gas-powered vehicles, building stations and other industry development, was introduced last year but failed to pass.

Interestingly, following the 2010 election in which Republicans made notable in-roads in Congress, President Obama expressed support for developing domestic natural gas resources. Lowering hydrocarbon emissions, reducing dependence on foreign oil and enhancing U.S. exports (e.g., liquefied natural gas) are causes most Americans would probably support, and they would all be auspicious for secular natural gas demand. The vagaries of politics may determine if they happen anytime soon.

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