Gas/Oil Ratio: Flashing an Extreme

My colleague, and Research Edge's Asian Strategist, Andrew Barber, told me the other day that he had a dream that we would one day all be driving cars powered by natural gas. While Barber is a great analyst who has nailed China this year, he is also a man of ideas. As of now, cars powered by natural gas are just that, an idea. We neither have the vehicles to do this, nor the infrastructure in place to deliver the natural gas. With all things, though, there is a price.

Currently, the oil / gas ratio is suggesting that price may be near as we are at an extreme in the price differential between the two commodities. In fact, the oil / gas ratio (the price of one barrel of oil divided by the price of one BTU of natural gas) is currently nearing 18x, which is 9-year high.

According to many experts, a barrel of oil contains roughly 6 BTUs of energy equivalence. On that basis, natural gas should be trading at ~$10.80 per BTU. Based on its current price of $3.93, natural gas is trading at just 36% of energy equivalent price. In theory, if oil stayed at its current price and natural gas reverted to its energy equivalency value, there would be ~175% upside to natural gas. As we know, in the real world arbitrage opportunities happen for a reason and the theoretical energy equivalency value is just that, theoretical.

Our competitor Dennis Gartman uses many ratios to justify his positions. On most, we would vehemently deny that there is a fundamental underpinning (Gold versus Agriculture as an example). With oil and natural gas, on the other hand, there is clearly some fundamental basis to consider this ratio since both oil and natural gas have an energy value that can be measured.

Some analysts suggest that on the industrial demand side, there is 5 – 10% overlap in oil and natural gas, which can be switched at different price levels. While this may be accurate, the most relevant data point relates to transportation. As the EIA reported last month in their year end natural gas review: “Natural gas for vehicle fuel has increased over the past several years but remains at less than 1 percent of the total.”

Until we see this number move meaningfully, it will be hard to argue that oil and gas are interchangeable from a usage perspective.

Investors who use history as a guide would suggest that either oil is over priced or natural gas is under priced. In the short term, they could both be correct. Longer term, the reality is more likely that we have entered an era of cheap natural gas and relatively expensive oil. Most importantly, oil has quantifiable supply constraints and burgeoning demand from emerging economies, most specifically China, while the natural gas market is flush with supply domestically and abroad.

We can see this change in growth of domestic supply of both commodities. In the simple table below, we have outlined the growth in domestic oil product and gas production in 2008 and 2000 versus 1990, with 1990 as the reference year. As we can see, on domestic basis, the market for oil has tightened dramatically. Since 1990 oil production on an annual basis in the U.S. is down -32%, while natural gas production is up 15%.

% change from 1990

Year ... Oil... Gas
2000 ... -21% 9%
2008 ... -32% 15%

While the oil / gas ratio is a relevant input for a fundamental view of the two commodities, until interchangeability becomes more prevalent between the two commodities, the history of the ratio is probably not the best guide to its future.

Comments

[mickeyhebert:]

Please get OFF the kick about natural gas and cars.
Natural gas is useful but should be for use in HEAVY/FLEET vehicles.
Cars would be nice, but natural gas is better applied where REAL POWER is needed. Lets modify Heavy Haulers and Fleet Vehicles first. Congress has sat on their posteriors far too long in the interest of party politics and their greed for $$$. Lets make decisions on what is good for AMERICA and AMERICANS.
The common link to our problems is Party Politics, a lack of courage and integrity in Congress and ill informed if not uninformed citizens.

May 29 08:17 AM

[john s. gordon:]

so oil is up & gas is cheap.
the commodity speculators are concentrating on oil since they sense that there is no $ to be made by speculating on NG.
> jack

May 29 08:40 AM

[User 421857:]

If you had written this a month ago, you would have been right to state "As of now, cars powered by natural gas are just that, an idea. We neither have the vehicles to do this, nor the infrastructure in place to deliver the natural gas." The Honda Civic GX is now being produced in Indiana. True, it's still a challenge to fill the vehicle. But it's a start.
www.thegreencarwebsite.../

May 29 08:42 AM

[mister b:]

gas to liquids seem to address problems of natgas excess capacity , clean diesel and home grown .

May 29 08:57 AM

[HATEFEEBAY:]

Natural gas used in cars and trucks is 20 years old! This article is absolutely irresponsible at best and ignorant. These were in Pittsburgh, PA back in the mid 1970's in fact-I saw them myself and driven by Columbia Gas employees and last I saw were still being used. They were also used by the local governments near Bethel Park, PA in the 80's and 90's. Idiotic article....

May 29 09:15 AM

[Alan von Al...:]

On May 29 08:17 AM mickeyhebert wrote:
> Please get OFF the kick about natural gas and cars.
> Natural gas is useful but should be for use in HEAVY/FLEET vehicles.

Exactly backward, dude. Passenger cars and local light duty truck and bus fleets on flat terrain first.

May 29 09:28 AM

[SL39:]

Keith:

The really important relationship to track is Gas vs Coal (since both compete in generation). The (raw -not including emissions costs) spread is at the lowest levels in the last 7 years.

Proof of the economics at play can be seen in EIA's Power Flash report of Feb and March 09. In both months generation was off 22 TWh (yoy) and yet gas fired generation was up 2/4 TWh (in spite of the much lower industrial activity). Coal burns are the adjusting variable.

Best,

Santiago

May 29 10:50 AM

[OilFinder:]

In Argentina, 15% of all vehicles on the road run on natural gas:
www.mcclatchydc.com/26...

In Pakistan, 764 CNG filling stations were built last year, bringing their total to 2,214. The government so far has granted license for over 6,000 such stations. And 80% of their vehicles have been converted to NG since 1992:
www.thenews.com.pk/upd...

If this can be done in Argentina and Pakistan, there's no reason why it can't be done in the US.

May 29 11:15 AM

[BrotherMaynard:]

SL39 (Santiago) is correct...to add to that, Credit Suisse had a note yesterday talking about the record stockpiles of coal that power plants have on hand:

“...the coal displacement story now seems less likely to further unfold given bearish power demand data and coal inventory data. Specifically, last week the EIA reported that March coal inventories held by utilities totaled ~175 million tons, up 12.4 million tons mo/mo (7.6%) and 28.2 million tons (19.2%) yr/yr. This represents the highest level in 26 years and also represents 75 days of supply, the highest in over 17 years. With EEI data showing power demand down 3.2% YTD versus 2008, utilities have built inventories rapidly and are therefore more likely to burn through coal stockpiles than to look to buy significant amounts of spot gas."

Nat gas just can't catch a break

May 29 11:19 AM

[Mad Hedge F...:]

NG is one of the few really cheap things out there. Those who missed the last 50% move in natural gas got a second chance to visit the trough this week, with the pull back to $3.50 from $4.59. Buying above an industry wide “cap in” price of $3.50 seems a no brainer to me, but is controversial nonetheless. This is a fraction of the $13.50 peak seen last year. You can bet that every electric power utility in the country is scampering to acquire advance supplies, many mandated by new environmental regulations to use the clean burning fuel, taking advantage of a rare opportunity to buy at the cost of production. Natural gas is still a steal at these levels for the long term. They don’t call this the widow maker for nothing, and if the volatility seems daunting, play in smaller size through the CME Emini contract, which only has $10,000 worth of underlying (2,500 MM BTU).

May 29 11:19 AM

[Jimbo:]

The Dutch have been using natural gas as a transportation fuel for many years. We have large reserves of natgas. But genius CHU of the Dept. of Energy is "agnostic"

May 29 11:26 AM

[john s. gordon:]

mister b -

it is true, NG to high octane gasoline via the Mobil process was used in 1976 and can be used again if anyone wants to.
> jack

May 29 12:24 PM

[jockum:]

NG fine as a transit toward Hydrogen gas. Hydrogen gas is currently the only viable long term goal, unless somebody comes up with a revolutionary battery. So, what we should do, is really go to Hydrogen gas directly. Why burn NG- it emits quite a bit, compared to Hydrogen.

May 29 01:28 PM

[tuj:]

New nat.gas is being found by the shedload. Crude is not. Nuff said.

May 29 03:04 PM

[elliot_mllr:]

The price disparity between oil and natural gas is exaccerbated by the weakness in the USD, which I believe is the main cause for the increase in the price of oil.

May 29 05:26 PM

[mickeyhebert:]

Alan,
Nice approach for personal convenience of those who drive, but not the best approach to lower cost for EVERYONE who eats, buys shipped goods etc.


On May 29 09:28 AM Alan von Altendorf wrote:

> On May 29 08:17 AM mickeyhebert wrote:

May 31 01:53 PM

[Charles Pet...:]

Just so you know, the historical ratio from 1980 to now is about 8.5:1 which accounts for the fact that the two commodities are not perfect substitutes. I agree that natural gas is definitely undervalued, but the short term fundamentals for natural gas are worse than that of crude oil because the U.S. is receiving a ton of LNG shipments. Over time this will move back to normal and both commodities will appreciate heavily.

May 31 06:10 PM

[sltinvestor:]

in the medium term too much supply is a problem - demand will eventually recover though.

Jun 02 02:59 PM

[john the ba...:]

the cure for a commodities low price is low commodity prices....

Jun 02 07:25 PM