Divergence Between Natural Gas and Oil Prices at Extremes

The divergence between natural gas and oil prices is at extremes. Oil prices have roughly doubled since early March lows yet natural gas prices continue to fall. This difference in prices has not been this wide since 1990 suggesting a long gas short oil trade, yet is may come from falling oil prices rather rising gas prices.

The number of rotary rigs for drilling natural gas has been cut in half from more than 1600 to less than 800 according to data from Baker Hughes, yet gas stocks continue to rise due to week demand and strong supplies. Industrial demand accounts for nearly one-third of natural gas-deliveries each year reports the EIA and rising supplies from unconventional gas fields such as Barnett Shale in Northeast Texas are upsetting the balance in the market.

Technological advancements including horizontal drilling have led to increased supplies at the expense of prices and hurts the marginal suppliers that dominate the Canadian market says James Cole, portfolio manager at AIC Ltd who remains bearish on the sector. Gas in storage increased again at the end of May and stands at 21.6% above the five year average ending 2008.

Despite the gloomy picture, one analyst thinks that the "seeds" of a natural gas recovery are "germinating" due to spending cutbacks based on weak pricing. Richard Wyman of Cannacord Adams believes that reduced drilling activity will eventually allow bombed out natural gas prices, trading at $3.80/MMBtu down from a high of $14 last year, to recover.

Wyman recommends positions in low-cost operators with strong balance sheets because the timing and magnitude of the recovery is uncertain. Given the sorry state of the market, playing it safe sounds like very good advice.

Comments

[paulito:]

President Obama needs to read this and put in place incentives to lure US companies and the public to change their focus from oil to natural gas thereby reducing the dependency on foreign oil. Not only will this help the gas producers this side of the world but it will lessen oil demand and cause those prices to fall taking away some of the money from foreign oil that may find its way into terrorist activities.

Jun 05 09:24 AM

[Ferdinand E...:]

It will "lessen" oil demand, but not soon - something else will have to do that. And I wouldn't be too optimistic about the amount of oil available for US producers.

Jun 05 10:56 AM

[Shale Gas:]

Penn Virginia just announced a successful well in the Haynesville Shale, which is not seeing a cutback in drilling, as operators are moving rigs from more mature areas to higher growth and lower cost shales.

Jun 05 11:09 AM

[E Nuff Sed:]

How do we play this? Buy UNG short USO? Let me know of other ideas.

Jun 06 05:54 PM

[IronCity:]

A friend sent me an idea for a covered call: buy UNG and sell Januaty 2010 call, strke 16 at 2.60.
Lowest UNG's price since this ETF begins: 12.69 (April 30, 2009).

Last closing price: 14.58
You get UNG at a net of 11.98 if in January price is under 16 (it is lower than the present historical price).

If your shres are called you will have a profit of $ 4.02 or a 33.5% over your investment (no commissions included).

I would greatly appreciate hearing opinions on this speculation.

Jun 07 10:55 AM

[Stone Fox C...:]

guess the way to play it depends on your perspective for your time period. The divergence in price will correct. If you believe inflation is on the way then you buy UNG. If you believe the rally is about to stall, you'd short USO. Not a huge fan of pairs trades. It just reduces your gains.

Jun 08 12:17 AM

[Shale Gas:]

I read that the current oil/gas ratio is 18 to 1. That can't continue.

Jun 08 09:15 AM