Oil and Natural Gas: Ratio Explodes in 2009

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

Comments

[Bluechippie:]

Cheaper natural gas price will be a greater incentive for power generator companies to switch to natural gas as as source of fuel instead of relying on expensive petroleum. If only Stephen Chu will ride on the bandwagon.......

Aug 26 11:32 PM

[BullnBear:]

I usually keep an 8/10 ratio on oil & gas but that may be changing if the trend continues and the gap doesn’t fill.

I’m looking for the U.S. dollar to strengthen at some point; I believe that the U.S. dollar weakness is the main catalyst for oil being at current levels. The U.S. dollar strength, (if/when), should drive the oil price back down but not to where the gap reaches the historic close level.

We need a long term natural gas usage catalyst, I generally get the feeling that something real or imagined will be created to clear this all within the next 18 to 24 months.

I never really believed that we would see the levels of intervention that we have seen in the last year across the markets in general so I don’t believe that the energy complex is going to stay immune from all of this for long.

Great article and I like your company picks in the last paragraph.

Aug 27 01:32 AM

[A Barrel Full:]

You guys look at this thing from a US point of view and I think that is misleading. The natural gas market is local whilst the crude market is global.

If the USA had LNG export (as well as import) capability, then natural gas prices would follow global prices.

If there were easily switchable power plants that used oil, then you would expect to see a better correlation between oil & gas prices.

The problem is that there are no easy, short term, large scale switching opportunities, so looking at ratios will not help you in the short to medium term.

Aug 27 02:11 AM

[Lojac:]

I agree with above comment too:
Great article and smart investment picks at end too.

Aug 27 08:11 AM

[manya05:]

To look at an oil/NG ratio as some natural law is misleading and wrong. Even if you equated energy content, as fuels, they are NOT the same and they cannot be swapped. Oil is becoming a transportation-only fuel, while nat. gas is essentially for stationary applications. What the market is saying (in my mind) is this: People will want to keep moving (driving, flying), we are reaching peak oil, there is no more oil out there, and there is NO viable cost-effective alternative to flying with jet engines, and driving with internal combustion engines (hybrids or straight). So, oil will be VERY scarce and valuable. Natural gas is not so critical to our survival, it can be substituted by other things (you can make electricity some other way, you can heat your house or cook some other way). But you CANNOT move without oil (at least not for a few more decades). The market is pricing in that premium, historical ratios are out the window.

Aug 27 01:18 PM

[Mark Divy:]

I completely agree with manya05

Kurt Wulff published an article back when oil was 150 BBL, saying NG would soon be at $20, Cramer calling for buys on NG during the oil spike due to the ratio.

Bottome line - they are not interchangeable - relationship does not work. Why keep beating the incorrect assumption that they are linked?

If you would like stock recommendations during a low cycle in NG, why not take a look at those that are underperforming their cash flow - due mostly to factors external to their business. BBEP is an example of a company with majority of NG (and oil) production hedged until 2011 - but has been beaten down of late due to lower NG prices (which do not hurt their cash flow) and temporary loan covenant issues that do not allow for paying dividends due to institutions lowering their available credit. BBEP has no credit problems, repaying outstanding loan balances every quarter, and plenty of cash to spare. Would suggest this one as a double - especially when they restart dividends in the not so distant future.

Aug 27 04:21 PM

[ETFdesk.com:]

I am playing this headline with (USO DBO USL UNG FCG) Ok so if you buy the argument that Oil : Nat gas ratio should fall from 25 to 1 back to 15 to 1 or lower, why not short Oil, Long Gas? How would you play it>?

track this over time...
tinyurl.com/ljrwkk

Aug 27 04:57 PM

[dano123:]

"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. "


You say the ratio will tighten due to falling oil as the economy recovers. So oil goes down when economies recover? Hmmm.....learn something new everyday.

Aug 27 06:42 PM

[Dian L. Chu:]

In my 7/13/09 article, I noted that I expect stagnation through 2010, as the economy slowly recovers, which would not have justified a $72/bbl oil price tag barring any hurricanes, geopolitical crisis, and 'excessive' speculations.
NatGas might move up from the current low's contributing to the ratio tightening, but to a much lesser extent than the movement from the crude oil side.
I beieve the ratio should move back to the historical range of 8 to 12 by the end of next year.

On Aug 27 06:42 PM dano123 wrote:

> "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. "
>
>
> You say the ratio will tighten due to falling oil as the economy
> recovers. So oil goes down when economies recover? Hmmm.....learn
> something new everyday.

Aug 27 11:13 PM

[Dian L. Chu:]

I would play it like this: Short the RBOB contracts and long natgas. why? See my article on the refining sector dated 8/11/09. Thanks for your keen interest in quite a few of my articles.


On Aug 27 04:57 PM ETFdesk.com wrote:

> I am playing this headline with (USO DBO USL UNG FCG) Ok so if you
> buy the argument that Oil : Nat gas ratio should fall from 25 to
> 1 back to 15 to 1 or lower, why not short Oil, Long Gas? How would
> you play it>?
>
> track this over time...
> tinyurl.com/ljrwkk

Aug 27 11:20 PM

[William M. ...:]

Many agree Oil is the logical pull-back price. Market economic forces are working on NG but not Oil. Yes, the dollar weakness is the killer. But they need to raise margin requirements.

Margin requirements on oil need to be closer to stocks requirements. Recall when the news blamed one trader using margin responsible for pushing Oil over $72, as the trade was unwound the price of oil declined for weeks? Remember? Now were right back to pushing Oil to $75. Yes, Oils inverse correlation to the dollar is the reason you have to toss out the old ratios. Sure the ratio was smaller in the 90's because the dollar was climbing. Looking at the statistics you can see the ratio changing back in 2003.

Now here is food for thought to show you how times change. Look at the price of NG back in 2002-2003. Now look at the price of DVN, APC or APA back then -I know I owned DVN and no one wanted to be these stocks back then but now everyone's looking to buy them on pull backs even though the price of NG has fall all year long and the storage tanks are full.

Aug 28 01:11 AM

[Ricard:]

Hmmm...another great article from Ms. Chu about what I'm sure is a popular deep value play.

I do have some questions. I'm looking at the APC charts and am comparing it to the Henry Hub. Seems there's no real correlation between the two...same for APA, BHI, KWK, etc...NG shows a slow, steady decline from July of last year onward, but not a single NG play displays the same pattern...except for UNG, which has its own issues.

Instead, what you see is exactly what you hear in the media - many people are loading on NG plays, even though NG itself is tanking.

Could NG really head lower, and could these speculators be taken for a ride? Is there anything out there that actually reflects spot prices to some degree?

Aug 28 02:27 AM

[Dian L. Chu:]

$APC, $BHI, etc. are not pure natgas plays like $UNG and thus have low or no correlation to natgas prices.
Unfortunately, most investment vehicles like $UNG are likely to be subject to regulatory overhaul, unless you play directly in the futures market. So I would recommend stay away from natgas ETF's till the dust settles.
Individual investors may trade futures at IB (Interactive Brokers); however, we all know about the higher capital requirement and risks involved.
Thanks for your comment, hope to see more often.


On Aug 28 02:27 AM Ricard wrote:

> Hmmm...another great article from Ms. Chu about what I'm sure is
> a popular deep value play.
>
> I do have some questions. I'm looking at the APC charts and am comparing
> it to the Henry Hub. Seems there's no real correlation between the
> two...same for APA, BHI, KWK, etc...NG shows a slow, steady decline
> from July of last year onward, but not a single NG play displays
> the same pattern...except for UNG, which has its own issues.
>
> Instead, what you see is exactly what you hear in the media - many
> people are loading on NG plays, even though NG itself is tanking.
>
>
> Could NG really head lower, and could these speculators be taken
> for a ride? Is there anything out there that actually reflects spot
> prices to some degree?

Aug 28 07:30 AM

[Dian L. Chu:]

The ratio tightening discussed in the article is based on my view of the global (and U.S.) economic stagnation scenario (low/no growth) in 2010, and ramp-up from 2011 onwards. Based on this, dollar, natgas, oil, etc. should resume the historical correlation/ratio pattern.
If you are looking at just 2010 or even 2011 timeline, then no, natgas prices are not going to take off to $6-8/mmbtu. That's why I recommended the investment options for long term investors.
Thanks for your comment.


On Aug 28 01:11 AM William M. Wright wrote:

> Many agree Oil is the logical pull-back price. Market economic forces
> are working on NG but not Oil. Yes, the dollar weakness is the killer.
> But they need to raise margin requirements.
>
> Margin requirements on oil need to be closer to stocks requirements.
> Recall when the news blamed one trader using margin responsible for
> pushing Oil over $72, as the trade was unwound the price of oil declined
> for weeks? Remember? Now were right back to pushing Oil to $75. Yes,
> Oils inverse correlation to the dollar is the reason you have to
> toss out the old ratios. Sure the ratio was smaller in the 90's because
> the dollar was climbing. Looking at the statistics you can see the
> ratio changing back in 2003.
>
> Now here is food for thought to show you how times change. Look at
> the price of NG back in 2002-2003. Now look at the price of DVN,
> APC or APA back then -I know I owned DVN and no one wanted to be
> these stocks back then but now everyone's looking to buy them on
> pull backs even though the price of NG has fall all year long and
> the storage tanks are full.

Aug 28 07:43 AM

[PairsTrader:]

You might want to check out companies like $CHK $DVN & $ECA. They are more natgas weighted producers, so their stock prices should have more correlation to the actual natgas.


On Aug 28 07:30 AM Dian L. Chu wrote:

> $APC, $BHI, etc. are not pure natgas plays like $UNG and thus have
> low or no correlation to natgas prices.
> Unfortunately, most investment vehicles like $UNG are likely to be
> subject to regulatory overhaul, unless you play directly in the futures
> market. So I would recommend stay away from natgas ETF's till the
> dust settles.
> Individual investors may trade futures at IB (Interactive Brokers);
> however, we all know about the higher capital requirement and risks
> involved.
> Thanks for your comment, hope to see more often.

Aug 28 07:57 AM

[Dian L. Chu:]

Thank you.


On Aug 27 08:11 AM Lojac wrote:

> I agree with above comment too:
> Great article and smart investment picks at end too.

Aug 28 09:17 AM