Oil and Natural Gas Prices Disconnect Again

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.

Another Look at Oil and Natural Gas Prices

A couple weeks ago, I discussed the remarkable divergence between the prices of oil and natural gas. At the time, the spot price of West Texas Intermediate was above $73 per barrel, while the spot price of natural gas at the Henry Hub was about $3 per MMBtu. The ratio of the two prices was at record levels, with the oil price 24.5 times the natural gas price.

Oil prices have declined since then, closing at $68.24 per barrel yesterday. But natural gas prices have also declined, closing at $2.82. As a result, the price ratio remains above 24, much higher than the 6 to 12 that’s been normal in recent decades.

To provide some more insight into what’s going on, I made a new graph to show the path of oil and natural gas prices since the start of 2001:

Natural Gas and Oil Prices - Sep 1 2009

The chart (squiggle, if you prefer) tracks the path of monthly average oil prices along the horizontal axis and monthly average natural gas prices along the vertical, plus yesterday’s closing data. Several features of the graph leap out:

Continue reading “Another Look at Oil and Natural Gas Prices”

Dodging the Resource Curse

Over the weekend, the Financial Times had a fascinating piece about Farouk al-Kasim, an Iraqi who is credited with saving Norway from the resource curse:

Poor countries dream of finding oil like poor people fantasise about winning the lottery. But the dream often turns into a nightmare as new oil exporters realise that their treasure brings more trouble than help. Juan Pablo Pérez Alfonso, one time Venezuelan oil minister, likened oil to “the devil’s excrement”. Sheikh Ahmed Yamani, his Saudi Arabian counterpart, reportedly said: “I wish we had found water.”

Such resignation reflects bitter experience of the way that dependency on natural resources can poison a country’s economic and political system. Inflows of hard currency push up prices, squeezing the competitiveness of non-oil businesses and starving them of capital. As a result, productivity growth withers (a phenomenon known as “Dutch disease” after the negative effects of North Sea gas production on the Netherlands). Meanwhile, the state institutions in charge of oil often become corrupt and evade democratic control. And oil-rich states almost invariably waste the income it brings, many ending their oil booms deeper in debt than when they started.

al-Kasim is credited with designing a system that struck a balance among a state-owned oil company, private oil companies, and an independent regulator:

The real achievement, in other words, was not finding oil but coping with its discovery. Norway faced the same dilemma as every other new oil producer with no experience of the industry: if you rely too much on private foreign companies, too little of the oil wealth benefits the country in the form of government revenue or economic development; if you go too far in the other direction, you risk a bloated, politicised oil sector that evades both accountability to the people and competitive pressures to be efficient.

The economic question is fascinating — how can you avoid the resource curse? — but you should also read the article for his unique personal journey (involving a child with cerebral palsy and one of the easiest job hunts in history).

P.S. Other coverage at Curious Capitalist and Kottke.

The Disconnect Between Oil and Natural Gas Prices

Yesterday marked a new record in the divergence between oil and natural gas prices.

As noted in a small item in the Wall Street Journal, the ratio of oil prices ($ per barrel) to natural gas prices ($ per million BTU) hit a record 24.5 at yesterday’s close. As you can see from the following chart, that’s far out of line with historical norms:

Ratio of Oil to NG (August 21 2009)

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 tend to 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 between 6 and 12 times the price of natural gas.

That’s changed in recent months. Natural gas prices have fallen to $3.00 per MMBtu, weighed down by new supply and weak demand. Oil prices, however, have stubbornly increased to more than $70 per barrel. That’s down sharply from the $100+ prices of last year, but up sharply from the $40 – $50 range earlier this year.

Where do prices go from here?

Continue reading “The Disconnect Between Oil and Natural Gas Prices”