The spot price of gas is simply the price you’d pay for a million British thermal units (BTU) of gas for immediate delivery. The front-month futures price is the first available futures contract; right now, that’s the October 2010 natural gas future traded on the New York Mercantile Exchange. The graph below depicts the rolling front-month gas futures contract since the end of 2005.

Source: Bloomberg

Natural gas prices are extremely weak right now, and the front month futures contract is probing new 2010 lows. In fact, prices have reverted to levels last seen at roughly this time one year ago. As you might expect, the weakness in front-month futures prices has soured sentiment toward many stocks leveraged to natural gas production, particularly natural gas-focused exploration and production firms.

But this front-month futures price isn’t that relevant to the industry’s fundamentals because natural gas prices are highly seasonal. Demand for gas is strongest in the winter months and weakest in the so-called shoulder season, the period between winter heating demand and summer cooling season. Gas prices tend to be higher in the winter months; in the two shoulder seasons in the spring and autumn typically bring the lowest prices.

October is the heart of shoulder season. Total natural gas in underground storage tends to peak in early to mid-November and decline as winter heating demand kicks in. Based on seasonal trends, October futures prices should be weak relative to prices earlier in the year; that the front-month contract recently sank below $4 per million BTU isn’t that surprising.

Fortunately, gas producers don’t sell all of their annual production in shoulder season. A more relevant measure of natural gas prices is the 12-month natural gas strip.

Source: Bloomberg

Gas futures are available that expire in every month of the year. The 12-month natural gas strip is the average price of the next 12-months worth of futures contracts. In this case, the 12-month strip would be the average price of every futures contract between October 2010 and September 2011. The strip is higher than the near-month futures price because it averages in the price of gas for delivery in the high-demand winter months.

The strip also makes more logical sense from a producer’s standpoint. Assuming a producer sells its output over the course of a year, the strip is the approximate average price they’d receive. And because most producers use the futures and forward markets to hedge production, the strip gives a good indication of prices a producer can lock in through hedges.

However, in this case, the trend in the 12-month strip isn’t much healthier than for the near-month futures. The price of gas recently slumped to its lowest levels since 2003-08 and is less than where it was at the height of the recession in late 2008-09. This pattern stands in stark contrast to the path of crude over the same period; oil prices have more than doubled from their 2008-09 lows and remain at historically elevated levels above $70 a barrel.

In the short term, fears or a repeat of last year continue to weigh on natural gas prices. In August and September 2009, US natural gas prices plummeted amid concerns that production would exceed storage capacity.

Natural gas is stored underground in salt caverns and in depleted natural gas fields. The nation has a large amount of storage capacity relative to other major gas-consuming and -producing countries partly because there are a large number of depleted oil and gas fields dotting the US.

But US storage isn’t infinite; the rapid rise in natural gas inventories one year ago pushed the limit of the nation’s capacity. At one point last autumn, pipeline operators were forcing producers to shut in wells because they didn’t have anywhere store new production. This glut sent near-month gas futures prices tumbling well under $3 per million BTU and pushed the 12-month strip lower as well. As you might expect, many gas-levered stocks were hit hard.

A repeat is highly unlikely this year because demand and supply conditions are more favorable than in 2009. Demand for natural gas from electric power producers has been elevated all summer.

Source: Energy Information Administration

This graph tracks consumption of natural gas by US electric-power producers over the past three years. There’s a clear seasonality to the data: Consumption is highest in the summer hear, and July and August are two key months to watch.

Although the US Energy Information Administration (EIA) releases data with a lag, electricity producers’ demand for natural gas is far higher in 2010 than it was in either 2008 or 2009. This is a function of two major factors. First and foremost, summer 2010 will go into the record books as among the hottest in the past three decades. The almost continual heat wave from Memorial Day to Labor Day drove record power demand–a stark contrast to the relatively cool summer 2009.

Second, there has been a significant amount of coal-to-gas switching. Electric power producers with the flexibility to use either coal or natural gas have used a bit more gas and a bit less coal this summer. For the most part this choice is driven by economics; cheap and falling gas prices encourage more demand for natural gas.

Even more important, weather conditions don’t entirely account for the uptick in demand; as we’ve written in previous issues, demand among industrial buyers continues to increase.

Source: Energy Information Administration

This graph compares industrial demand for natural gas in 2010 to the five-year maximum and five-year minimum. As you can see, industrial gas demand has trended toward the highest levels in five years. When you consider that this period includes the strong economic environment before 2007-08, that’s an impressive showing.

The boom in shale-gas production has been offset to some extent by unusually strong demand for natural gas in 2010; although natural gas storage levels are above average, the glut is nowhere near as pronounced as it was one year ago.

Source: Energy Information Administration

This graph depicts total US gas in storage compared to the five-year maximum and five-year minimum levels. At one point this spring, storage levels in the US set new five-year highs and were well above 2009 levels. But as the summer has progressed, the seasonal build in gas storage has actually been far less than normal. This effect has been particularly pronounced since early July, roughly the time when the US heat wave intensified.

Last year storage topped out near 3.9 trillion cubic feet before falling off sharply in November, when winter weather began to increase demand. However, unless there’s a prolonged period of milder weather in September and October, it’s unlikely that US gas in storage will match last year’s elevated levels. As such, last year’s storage concerns aren’t likely to make an appearance in 2010.

US natural gas prices should find a seasonal bottom over the next month or so.

Although near-term supply conditions in the natural gas market have hit sentiment surrounding US natural gas-focused producers such as Chesapeake Energy Corp (NYSE: CHK) and Cabot Oil & Gas Corp (NYSE: COG), our favorite master limited partnerships (MLP) should see little or no impact from the near-term price gyrations in natural gas.