Oil to Natural Gas Price Ratio

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 |  Includes: UNG, USO
by: Toro

I am hearing a lot of chatter about the price of natural gas, particularly the ratio of the price of oil to the price of natural gas. Historically, the ratio of oil to gas has been 6:1 to 10:1. This week, that ratio soared as high as 26:1.

People are using this ratio as a reason to jump into natural gas, seeing it as extraordinarily cheap relative to oil. But is it? If you look out onto the strip, you will see that the ratio collapses out a few months (click to enlarge).

Oil to gas 09 08

"M" stands for month out, so "M4" is four months out. The ratio is 14:1 at the end of the year, still high but not as high as it first seems.

If you try to play the convergence of this ratio through the futures market or by owning the UNG, you are betting that the prices of near-term contracts will soar as this ratio should fall just by allowing the futures to roll over.

Now, I do not know if the near-term price of gas will jump. (I placed a bet several days ago that it would bounce as it was very oversold but liquidated the position when it became apparent I was wrong.) However, inventory is swamping the gas markets, and storage is tight, so the price could still go substantially lower. Not saying that it will, rather that sometimes markets can go further for longer than one could imagine.

This is the natural gas strip (click to enlarge).

Nat gas string 09 08

The horizontal axis is the natural gas futures price for outer month contracts. For example, "ng3" is the natural gas price for three months out, or the November futures contract.

Prices in the outer months have fallen over the past few weeks but less so than the near-term contracts. This is one reason why the stock prices of natural gas companies have held in fairly well even though the spot price of nat gas has collapsed as natural gas producers sell their product across the strip.