Update (4/9/10): Please see my follow-up post as well.
Last summer I noted that oil and natural gas prices had diverged to an unprecedented degree. I bravely predicted that this divergence would reverse (unbravely, I didn’t predict when).
As the chart below shows, I was right: the price relationship did move sharply toward normal levels. In the last two months, however, it’s blown out again:
The chart shows the ratio of the price of oil (measured in $ per barrel) to the price of natural gas (in $ per MMBtu). Under normal circumstances, that ratio fluctuates between 6 and 12. A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would thus tend to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded higher.
Natural gas closed today at $4.11 per MMBtu. Under normal circumstances, that would imply an oil price of around $25 to $50. But oil actually closed above $85. As a result, the ratio of oil prices to natural gas prices is up at 20.7, well above the usual range and closing in on the peaks of last summer (on the day before I wrote my earlier piece, the ratio reached 24.5).
Where do prices go from here?
Well, history still suggests that the price gap will eventually narrow, through some combination of oil prices falling and natural gas prices rising. But there’s no guarantee that will happen in the short-run. Over the longer-term, however, I feel confident that demand for natural gas will rise to meet the new supply (the prime reason why natural gas prices have been so low recently) and that the oil vs. natural gas price relationship will eventually move back to normal. Natural gas is cleaner than coal and is available in large quantities in the U.S. and Canada. As a result, natural gas is on the short-list of potential responses to climate change and oil dependence, two concerns that aren’t going away anytime soon.
Note: The chart uses the spot price for West Texas Intermediate at Cushing and the spot price for natural gas at Henry Hub. Both series are monthly, except for the prices for today, 4/01/10.
P.S. Note that I have again obeyed the first law of forecasting: I have given a prediction (the relationship between oil and natural gas prices will normalize), but I haven’t given a date.
Seems to me that this is a sign of artificial inflation of oil prices. The demand of crude has not increased dramatically, and although there have been large discoveries of natural gas they have been bought up very quickly showing a high demand as well (Exxon buying XTO).
Thanks for revisiting this topic, Prof Marron.
It is very strange that so few commentators have noticed this divergence. The last time oil broke out above $85, the oil/natty gas ratio wasn’t so out of whack.
You could perhaps be a bit more brave and point out that “this time it’s different”. (I.e. we’re not likely to see $150 oil this summer, since it would imply a radical jump in either the natty gas price or the oil-gas price ratio).
However, the second rule of forecasting is never utter the words “this time it’s different”, so I don’t blame you. 😉
It is far more likely the spread will increase to 25 before the summer is out, next winter may bring a 20 spread or less but not much less.
I’m more interested in the correllation betw. crude prices and pump prices. In the last few weeks, since the Gulf oil spill, spot crude has dwindled down to the upper $70’s from the upper $80’s, meanwhile pump prices have gone in the opposite direction. This disconnect is way more important to the avg. consumer esp. with the advent of another long summer.
Is it possible that the only legal vertically integrated supply chain is being controlled to maximize profits?
Do you expect the price of oil to increase with Chinese demand?
Will the oil companies lower the prices for a year or two when viable electric cars begin to sell in quantities?
If we want cheaper transportation we should pursure any viable alternative to fossil fuels, i.e. electric or hydrogen fuel or alge diesel. Once the viability of an alternative is available the Chinese will adopt it unencumbered by the oil interest groups.
In the interim a higher tax on fuel would help curtail the trade deficet and reduce consumption. Thank you for the informative article on the price ratio with natural gas.
I believe that the wholesalers have been taking an advantage of these situations for many years. Any time an oil disaster is in the news gas prices are jacked up with no correlation to the price of crude. The Summer blend should actually be less expensive to produce seeing that most states require a minimum of 10% ethanol or 15% MTBE in wintertime and those additive are far more costly to produce and you have to add in transportation costs as well because the majority of ethanol is produced in the midwest, not near the coastal refineries or mountain west refineries. Syracuse is where the wholesalers of gasoline store their inventories for Western NY. In the industry the cities of Rochester, Buffalo and Niagra Falls are known as the “Gold Coast” for excessive gasoline prices. The differences in prices from Syracuse and the Western portion of NY can be as much as 20%, and premium gasoline is even greater. The truth is, is that premium fuel cost only a tiny bit more than a penny for premium, but at most Sunoco’s (who carry NASCAR logos) charge as much as 40 cents more per gallon. This is typically ignored by most people because most engines requiring premium gasoline are high end sedans, sports cars and motorcycles. A lady driving a 12 cylinder Mercedes comment to me that she would gladly pay the extra because her car knocked and pinged with 87 grade full. The truth in fact is that her car is actually malfunctioning because most cars that run better with Premium should only lose a minimal amount of horsepower and not knock and ping. All modern cars have systems that measure for knocks and pings and adjust their spark to fire prematurely or a little late to prevent this, but this urban legend truly exists. Motorcycles are the true exception because the burn at such great pressures and cycle so fast (many redline above 16,000 rpms) that a high octane is truly required as is a differnt kind of oil because this oil lubricates the transmissions of motorcycles as well as the engine and therefore can’t contain cleansers with foaming agents that would lead to broken transmission. Only when you see a legislator call for a special investigation regarding price fixing between stations. I have seen this more than once in my life, most recently 2 years ago when the congressman from the southern district of Rochester requested this very investigation. However once you crossed into his congressional district, prices dropped by 20 or more cents per gallon.
The very source of this burden to the final buyer is the constant greed starting at the oil company to the wholesalers and individual gas station. For you to change this behavior you must be aware of this and be choosy at where you fill up and write store owners and local congressman to do their jobs watching the local markets.