Rethinking Oil and Natural Gas Prices

My recent post about oil and natural gas prices elicited some very constructive responses from readers (thanks in particular to PJ, MF, and FW, in addition to public commenters on the post). As a result, I’ve rethought my discussion of the relationship between oil and natural gas prices.

I was also inspired to look at the futures markets to see what they are signaling about the relationship between oil and natural gas prices. Here’s my usual chart of the ratio of oil prices to natural gas prices, now showing both history (lighter blue) and futures markets (darker blue):

As noted in my earlier posts, oil and natural prices appear to have disconnected from their historical relationship. For many years, oil prices (as measured in $ per barrel) tended to be 6 to 12 times natural gas prices (as measured in $ per MMBtu). That ratio blew out to more than 20 in late 2009, then receded to more traditional levels, and then blew out again in recent months. At yesterday’s close, the ratio stood at 21.8, far above its historical range.

In my previous posts, I argued that this unusual pricing reflects the sudden (and welcome) increase in natural gas supplies and that we should expect oil and natural gas prices to eventually move back toward their historical relationship as markets absorb the new gas. Of course, I was careful not to say when this would happen.

As shown in the graph, the futures markets are indeed signaling some normalization in the price ratio in coming years, but not a rapid one. Moreover, even after eight years, the ratio would return only to the upper end (12) of its historical range. (Caveat: Futures markets are quite thin that far out, so we shouldn’t place too much weight on those distant prices.)

Let me offer a revised interpretation of the pricing relationship that’s consistent both with the futures data and the comments I received. This interpretation (consider it a theory, really) distinguishes four time periods:

  • Good Old Days: For many years, the electric utility industry had generating plants that ran on oil, natural gas, or both. The ability to fuel switch (either by changing the dispatch order of oil and gas plants or changing fuels at plants that could use either) limited how much oil and natural gas prices could deviate. If oil prices fell too low, utilities would move from natural gas to oil, and vice-versa. Similar fuel arbitrage occurred, to varying degrees, among other uses as well (e.g., home heating and some industrial uses).
  • More Recent Days: In recent decades, electric utilities have embraced natural gas and moved away from oil. As a result, there is much less opportunity for arbitrage between the fuels. The same has happened among other fuel consumers as well. Oil and natural gas prices nonetheless remained within their usual historical relationship. For example, oil and natural gas prices rose and fell in tandem during 2008. This suggests that the markets encountered similar shocks during those years (e.g., strong demand or, some would argue, speculation), not that they were linked via arbitrage.
  • Today: With the decline of traditional fuel arbitrage possibilities, oil and natural gas prices can now move separately if they experience distinct shocks. That appears to have happened with the increase in natural gas supply, for example.
  • Future: Looking further ahead, however, one would expect some new arbitrage relationships to develop. If we have persistently cheap natural gas and persistently expensive oil, that creates an incentive for ingenious folks to find ways to use natural gas to serve what have traditionally been oil demands. That should eventually limit the degree to which the prices can deviate (although not necessarily in the 6 to 12 ratio range). Two leading candidates for this linkage are using natural gas as a transportation fuel (directly as a fuel and perhaps indirectly as electricity) and increased international trade in liquified natural gas.

Note: The chart uses the spot price for West Texas Intermediate at Cushing and the spot price for natural gas at Henry Hub on a monthly basis through March 2010. For April 2010, I use the closing prices on April 8. The monthly futures are from the CME Group.

7 thoughts on “Rethinking Oil and Natural Gas Prices”

  1. Oil is now essentially used in only its hardest to displace uses. Mostly, transportation fuels.

    Gasoline, jet fuel, diesel.

    There will always be someone to come along and point out that oil feeds other things – petrochemicals, etc. – but in general refneries produce as much of the transportation fuels as they can. The other products are essentially by-products.

    So, in the past, when oil was used for lower value easier to displace uses, there was more opportunity for switching.

    In the future, if things stay on the current path, there will likely be inroads made by gas into transportation fuel markets. The most likely areas would seem to be natural gas vehicles, or electric vehicles using gas-fired electricity.

    But these paths to the future have their ways of changing. Wasn’t so long ago that gas was looking like it was going to be an increasingly expensive commodity domestically and we were going to have to import foreign LNG just to keep up with existing demand. This would have been the prevalent view through at least 2002-2003.

  2. There is some extra capital of using natural gas in place of oil. If a vehicle would use a PV of $20,000 in gasoline during its lifetime and a vehicle giving the same service whould use $8,000 worth of natural gas then the extra cost of a fuel system using natural gas must be less than $12,000 if fuel users are to buy the natural gas vehicle. The substitution of natural gas for gasoline depends not on the RATIO of the price of one to the price of the other but on the arithmetic DIFFERENCE between the price of gasoline and the price of natural gas.

  3. I predict a NG whipsaw. Issues in the gulf following RIG’s and BP’s platform will once again trigger the liberal anti-business, anti-oil, anti-natural gas factions to create legislation to promote a silly and costly agenda. This will have the effect of reducing domestic oil and gas production taking out a number of marginal wells. Further the anti-business epa is concerned about shale bacteria and NG bacteria. This will cause a further reduction in production. While the US economy is essentially flat on its back, we get reports of oil and NG stockpile which are actually just a few % higher than historical averages. With reduced production and even anemic US business activity, the demand will soon reach the point where replenishment is necessary and gov will have us bottled up. This will trigger sharp demand for NG and oil. So by August prices will soar through to the year end. I expect oil to go to $150 and NG to hit 10 or even 15 reclamping the ratio at about 10:1. What most models are not observing is the huge demand for oil and gas in emerging economies, especially China, Korea, India and Brazil.

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