Oil and Natural Gas: Ratio Explodes in 2009

 |  Includes: APA, APC, CVX, IEO, IXC, XOM
by: EconMatters

Theoretically, based on an energy equivalent basis, crude oil and natural gas prices should have a 6 to 1 ratio. However, due to various market characteristics, the price of oil has been following a pattern of 8-12X that of natural gas since 2006. Now, with oil spiking to its highest level this year and natural gas plummeting to a 7-Year low to below $3/mmbtu, the current ratio of WTI/Henry Hub price is close to 25 to 1, a historical high. (Fig 1)

Natural gas tends to be regionally based and is typically less impacted by external sources. Oil, on the other hand, is a commodity with global demand drivers; and along with gold, trades as an inflation hedge against a weakening US Dollar (click on chart to enlarge).

Natural Gas Prices Rooted in Supply & Demand

The domestic natural gas price weakness is rooted in supply and demand. Factories and power plants have slowed production because of the weak economy. The Energy Department reported that consumption of natural gas was down about 5% year-over-year in May. (Fig. 2, click to enlarge) On the supply side, a boom in domestic production has followed improvements in recent years in drilling technology, opening immense shale gas fields across Appalachia, the Great Plains, Northern Texas and Louisiana.

The industry is laying down gas rigs at a record pace over the first half of the year. Based on the latest Baker Hughes rig count, the number of gas rigs in the U.S. has been reduced by about 45% since last August. But production has remained high partly because many of the shale wells are new and just beginning to flow. In addition, there is typically a 3-6 month lag for production to really shut in due to the complexity of unconventional shale gas operations. In fact, natural gas output this year has been slightly higher than last year despite the sharply declining rig count. (Fig. 2, click to enlarge)

Demand & Inventory

U.S. crude and gasoline inventories are at the top of the five-year range. However, the current lofty crude price at around $72 a barrel has a lot more down side risk than that of natural gas in the near term, given the recent sluggish demand forecast by the IEA. The IEA forecasts oil demand growth next year to be 1.6% after declining 2.7% this year.

Natural gas inventories are also at 15-year high in any August month. The latest EIA Short-term Energy Outlook projects that total U.S. natural gas consumption will decline by 2.6% in 2009 and increase by only 0.5% in 2010. That means natural gas prices are not likely to rebound to the previous trading range of the last 5 years between $6-$8/mmbtu anytime soon, assuming no hurricanes or other events taking produtions off line.

Nymex Natural Gas Futures

The recent lows in the $2.70s is far from the projected price at the start of 2009 by most analysts of around the $5 level for the second half of the year on increased demand due to an improving economy. Currently, the December Nymex natural gas contract is the only month trading at the $5 level. October & November contracts have already been adjusted down along with the recent 3-week slide in the front month contract. (Fig. 3, click to enlarge)

It should be noted that things can change fast in the natural gas market. But still this weakness in natural gas prices due to poor fundamentals has caught many poorly positioned. And the losses have been severe for all with unhedged exposure to the commodity.

Ratio Tightening to Come from Oil

The total divergence between oil and natural gas prices, which is reflected by the unprecedented 25 to 1 ratio is unsustainable based on the factors discussed here. We should expect the ratio to narrow with most of the tightening likely coming from the retracement of oil prices to the downside. While it is difficult to expect a 10 to 1 ratio, some tightening towards 15 to 1 level could be in the cards by next year, depending on the pace of the global economic recovery.

Investment Strategy

For long-term investors, now is a good time to add some natural gas related holdings. However, since most of the commodities ETFs, in addition to market risks, will likely face the regulatory overhaul as discussed in “Natural Gas ETF Suspends New Shares: Are There Alternatives?”, a better strategy would be to invest in the natural gas E&P equities as well as ETFs.

Here are some ideas: Natural gas and LNG producers with international operations such as Apache Corp. (APA), Anadarko Petroleum Corp. (APC), ExxonMobil (XOM) and Chevron Corp (CVX) are all solid companies worthy of a seat in any portfolio. And iShares Dow Jones US Oil & Gas Exp. (IEO), and iShares S&P Global Energy Sector Index Fund (IXC) are two good examples for your ETF considerations.

Disclosure: No Positions