In previous posts (most recent here), I noted that oil and natural gas prices have disconnected from their usual 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, briefly receded toward more traditional levels, and then expanded again. At Tuesday’s close, the ratio stood at 19.4, far above its historical range:
(Note: 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.)
The unusual pricing of the last two years reflects two factors. First, there has been a dramatic–and welcome–expansion in domestic natural gas supplies. That’s driven natural gas prices down to less than $4 per MMBtu at yesterday’s close. Second, there is limited opportunity for energy users–utilities, businesses, and homeowners–to switch from oil to natural gas. Years ago, such switching linked oil and natural gas prices relatively closely. But today those prices appear largely decoupled.
All of which poses an important question for investors, forecasters, and industry planners: Will historical relationships eventually reassert themselves, perhaps by longer-term fuel switching by utilities and transportation fleets to natural gas? Or is this time really different, with old pricing relationships no longer relevant?
One way to answer that question–or, at least, to get some insight into how others are answering it–is to look at futures prices. As illustrated in dark blue above, those prices imply that the ratio of oil to natural gas prices will remain well above historical levels for at least the next eight years. The new normal, according to futures markets, will be for oil prices to average about 15 times natural gas prices.
Hi Don.
As an oil and gas investor, I get the sense that the historical oil/gas ratio should have little bearing on current or future ratios based on your analysis.
As you mentioned above, each fuel source is an imperfect substitute for the other in terms of the end use. For example, 30% of natural gas is used for electricity generation compared to 3% of crude oil. Residential demand for natural gas represents about 20% of total use and only about 4% for crude oil. Transportation uses for natural gas are about 1% compared to about 70% for crude. (Note: these percentages are very quick and dirty estimates).
Is it logical to assume that two hydrocarbon based energy sources with very different physical properties (liquid/gas) and end use demand weightings should exhibit a stable* range-bound price ratio? I don’t think so unless and until distribution logistics and the end use weightings become more similar over time (more perfect substitutes).
To answer your question, my thinking is that old pricing relationships may no longer be relevant (ceteris paribus) . . . IF they ever were relevant given imperfect substitution between crude and natty. 😉
In short, I think you answered your question on whether old pricing relationships are still valid with the statement, “…the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded higher.” The higher price per btu for crude is partially being driven higher in light of the dynamic growth in automobile sales, and petroleum consumption, in Asia over the past few years. My memory is that U.S. and European consumption of transportation fuel is flat or slightly declining while in Asia it is growing sharply (on a much lower baseline).
Another key difference between the two hydrocarbons is that crude oil is traded in a global market with a, more or less, single global price (albeit with different prices for different grades). Natural gas is mostly traded in regional markets due to distributional friction with prices varying based on regional market fundamentals.
Great post!
Thanks!
Scott Nystrom
*This statement assumes a range of 6 to 12 oil to natty ratio is mutually agreed upon to be “stable.”
My take is that there are two potentially two boundaries in any market: a lower bound, where ‘production destruction’ sets in, and an ‘upper bound’ where demand destruction sets in.
Historically, natural gas and crude oil have both generally been comfortably supplied – with the odd ‘shock’ – and have bounced around at the lower bound while maintaining largely the same price relationship.
Crude oil has in recent years firstly been approaching supply constraints, and secondly it has become thoroughly financialised around the Brent/BFOE complex of contracts which sets the physical market price. By contrast, natural gas has not become globally financialised and is regionally fragmented, as stockstrategist rightly says.
In my view, the crude oil price is being kept supported by one or more producers with the complicity of investment banks, in very much the same way that Hamanaka was able to manipulate the copper market for five years before being rumbled, and then another five years after that.
They are able to achieve this because they essentially are able to borrow money at zero % from ETFs, who are in fact anything but speculators, being motivated by loss avoidance considerations to be ‘long only’.
Ask yourself cui bono from high oil prices. Speculators are agnostic as to price, but desire volatility.