If you classify yourself as a contrarian investor, you may be tempted to take a long position on the natural gas sector right about now.

After hitting almost $14 per MMBtu (million British thermal units) as recently as last July, gas prices have been on an express elevator to the basement. Prices recently breached the $4 per MMBtu barrier, a price level not seen since 2002 and almost unthinkable just a few months ago.

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Market sentiment is almost universally grim, reinforced by a fundamental backdrop that offers scant hope of any recovery in price for the foreseeable future.

Economic Downturn Curtails Natural Gas Consumption
According to the latest monthly Short-Term Energy Outlook report published by the U.S. Energy Information Administration (EIA), demand for natural gas by industrial users is set to tumble by about 6% this year, causing overall domestic demand to drop by 1.3%. Industrial users account for 29% of total natural gas consumption.

Producers of fertlizer, chemicals, steel and other metals, which consume significant amounts of gas in their production processes, have been trimming production in the face of collapsing demand. Recent casualties include steelmaker Nucor (NYSE:NUE), which had shares fall nearly 10% after its report of a first-quarter loss, and aluminum producer Alcoa (NYSE:AA), which had to slash its dividend 82% in the face of slumping metals demand.

Residential and commercial customers are also trimming their gas usage as tough times prompt cost-cutting moves.

Supplies Keep Growing
Looking at the supply side of the equation, things are equally bearish. Gas inventory levels in the most recent reporting week remain stubbornly high at 13% above their five-year average. Last year's supply surge from many of the recently discovered shale gas formations continues to remain trapped in the system. Total U.S. marketed production soared by 7.2% in 2008, while demand increased by only 0.8%. (To learn more about the supply and demand relationship, check out the Demand And Supply section of our Economics Basics Tutorial.)

However, lower prices are prompting U.S. domestic producers to cut back on further drilling and hence production, with some analysts projecting a drilling slowdown of as much as 40%. Major gas producers like Devon (NYSE:DVN) and Chesapeake (NYSE:CHK) have slashed their 2009 exploration budgets. Since gas prices peaked last year, both companies' shares have tumbled 60% and 75%, respectively. But despite the drilling cutbacks, the EIA still sees domestic production remaining flat this year and falling by only 0.8% in 2010.

Foreign Gas Supplies Another Headache
The drastic slowdown in industrial activity in Asia and Europe promises to increase the flow of foreign liquefied natural gas (LNG) to America's shores. In 2008, U.S. LNG import capacity more than doubled. Import numbers for March could show as much as a 35% increase.

The Bottom Line
With natural gas stocks facing a perfect storm of declining demand and surging supply, any recovery for this sector has to be a compelling contrarian bet at this juncture. The fact that large speculators recently trimmed their short positions on gas by 11% last week suggests that more than a few players are willing to make such a bet.

For further reading on investing in companies such as these, be sure to read our Oil And Gas Industry Primer.
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Tickers in this Article: DVN, CHK, NUE, AA

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