HOUSTON (Dow Jones)--Natural gas futures finished lower Friday, dropping below the $3 mark, as swelling natural gas storage levels and tepid demand weighed on the market.

Natural gas for October delivery on the New York Mercantile Exchange settled 29.6 cents, or 9.09%, lower at $2.960 a million British thermal units. The contract rose as high as $3.424/MMBtu in earlier trading and then turned down, surrendering much of Thursday's gains when gas prices shot 15% higher.

"[Thursday] was quite a run, so naturally you are going to have some give back. The near-term fundamental outlook is still very bleak," said Cameron Horwitz, an analyst with SunTrust Robinson Humphrey in Houston.

Natural gas prices spiked higher on Thursday after the U.S. Energy Information Administration reported that natural gas in U.S. storage grew by 69 billion cubic feet last week. The build was less than analysts had expected, prompting traders to buy back previously sold contracts.

Storage levels, however, are still on pace to reach record levels or even test capacity by winter, when heating demand begins cutting into stocks of the fuel. Natural gas output has remained high and demand for the fuel has fallen amid the economic downturn.

Natural gas in U.S. storage for the week ended Sept. 4 stood at 3.392 trillion cubic feet - 17% higher than both last year and the five-year average. The EIA projects that storage levels will rise to 3.840 trillion by the end of October, near its estimated peak capacity of 3.889 trillion cubic feet.

Tim Evans, an analyst with Citi Futures Perspective in New York, wrote in a note to clients on Friday that an uptick in weather-related demand for natural gas-fired power or a storm that shuts in production could help shift the balance between supply and demand.

"But we're really expecting a downtrend in production to eventually do that job," Evans wrote.

Natural gas producers have pulled back on U.S. drilling activity as the economy slipped into recession and prices began to fall.

The number of rigs drilling for natural gas fell to 699 this week, a decline of two rigs, according to data from oilfield services provider Baker Hughes Inc. The number of rigs drilling for natural gas has fallen by more than half since last September, when the gas rig count peaked at 1,606.

Forecasters were monitoring a tropical disturbance in the U.S. Gulf of Mexico that could bring heavy rains to the northern Gulf Coast.

"We don't expect to see any further development out of this [weather] feature," said Matt Rogers, a meteorologist with the private forecasting firm Commodity Weather Group. Rogers noted that wind shear would prohibit tropical cyclone formation.



FUTURES SETTLEMENT NET CHANGE
Nymex Oct $2.960 -29.6c
Nymex Nov $4.011 -23.8c
Nymex Dec $4.769 -18.7c

CASH HUB RANGE PREVIOUS DAY
Henry Hub $2.89-$3.06 $2.61-$2.75
Transco 65 $2.92-$3.00 $2.69-$2.79
Tex East M3 $3.05-$3.21 $2.90-$3.03
Transco Z6 $3.06-$3.21 $2.84-$3.03
SoCal $3.03-$3.19 $2.75-$3.00
El Paso Perm $2.88-$2.96 $2.61-$2.77
El Paso SJ $2.84-$2.94 $2.65-$2.76
Waha $2.90-$3.00 $2.57-$2.76
Katy $2.90-$3.03 $2.55-$2.73

-By Jason Womack, Dow Jones Newswires; 713-547-9201; jason.womack@dowjones.com