Natural Gas Is Cheap Compared to Oil

A couple weeks ago, I discussed the remarkable divergence between the prices of oil and natural gas. At the time, the spot price of West Texas Intermediate was above $73 per barrel, while the spot price of natural gas at the Henry Hub was about $3 per MMBtu. The ratio of the two prices was at record levels, with the oil price 24.5 times the natural gas price.

Oil prices have declined since then, closing at $68.24 per barrel on Tuesday. But natural gas prices have also declined, closing at $2.82. As a result, the price ratio remains above 24, much higher than the 6 to 12 that’s been normal in recent decades.

To provide some more insight into what’s going on, I made a new graph to show the path of oil and natural gas prices since the start of 2001:

The chart (squiggle, if you prefer) tracks the path of monthly average oil prices along the horizontal axis and monthly average natural gas prices along the vertical, plus Monday's closing data. Several features of the graph leap out:

• As expected, the two prices are positively related, with high oil prices generally being accompanied by high natural gas prices, and vice-versa. Most notable, perhaps, are the period of low prices early in the decade (lower left of the chart) and the period of very high prices in 2008 (upper right).

• Sometimes the relationship breaks down, however. Natural gas prices skyrocketed in late 2005, for example, without much movement in oil prices.

• Today, the divergence runs the other way. Natural gas prices are remarkably cheap in absolute terms and relative to oil prices, at least in spot markets.

To drive that last point home, note that the last time natural gas prices were below $3.00 per MMBtu, oil prices were below $30 per barrel. Similarly, when oil prices have been near $70, natural gas prices have been around $6.00.

In response to my previous post, several readers asked whether there was any obvious way to profit from this divergence in prices. Well, one way is to buy natural gas today, put in it storage, and hope to sell it in the future at a higher price.

There’s just one problem with this strategy: People are already doing it. As a result, natural gas storage facilities are close to overflowing. As Monday’s Financial Times reports, that creates a risk that spot prices will fall even further. Indeed “a 2006 gas glut in the UK briefly pushed wholesale prices there below zero.”

Comments

[aarc:]

As one commentator in SA said before: Buy nat gas when the storage facilities are already full to the brim.

Then sell them when the facilities turned ... going empty? .

I think there's a reasonable logic to that comment.

Sep 02 08:06 AM

[luckyLA:]

Hallo, there were full boats of oil in February and now is 68-75 from 40. Do you believe that somebody will sell NG for 0 with some additional discount to customers?

Lumir

Sep 02 08:32 AM

[Mad Hedge F...:]

By miles. “When do I buy natural gas” is the most frequent question I am getting from clients these days. I can’t blame them, after watching CH4 dive from $13.50/MCF last year to a September contract low of $2.72. Massive new discoveries and an unusually cool summer is causing a looming storage shortage that has hammered longs. Those who dove in early have been punished, with stop outs followed by stop outs. The bizarre thing is that gas went up in flames while crude more than doubled, from $32 to $77, leaving pros stunned and speechless. The crude/gas ratio has soared to an unimaginable 27 times, up from a mere four times in the last decade. On a BTU basis, gas is now only 25% the cost of oil, it burns cleaner, with only half the carbon dioxide output, and is cheaper than high grade coal. Natural gas at these prices is another way of buying oil at $18 a barrel, with less pollution. Industry insiders don’t see it falling below $2/MCF, the breakeven cost of the longest term producers, where the shut off valves will start creaking en masse. Existing gas fields deplete at 25% a year, and the 60% cut in new drilling this year will deliver a rebound in prices by next winter. Longer term, the Pickens plan and the conversion of a large part of our national power generation to natural gas will drive prices higher. In the end, I think the final low will be defined by another Amaranth type disaster, where a super leveraged long hedge fund gets wiped out and is then liquidated under the worst conditions imaginable. In 2007, the Amaranth debacle took gas from $17 to $4 in the blink of an eye. Where Amaranth 2.0 will take us is anyone’s guess. But when it happens, possibly as early as September, other big hedge funds will stampede in like feral cats lapping up spilled milk. If I lived over a giant salt cavern, I would be pumping it full of natural gas now. But since these formations don’t exist in Northern California, I shall have to content myself with the futures markets, where longer dated contracts are selling at big premiums. Email me at madhedgefundtrader@yah... if you need help getting set up on the futures. For those not looking for an “E” ticket ride, it may now be time to Hoover up the leveraged natural gas equity plays like Chesapeake (CHK), XTO Energy (XTO), Southwestern (SWN), and Petrohawk Energy (HK), which appear to have already bottomed.

Sep 02 10:32 AM

[Elliott:]

There are two camps: one camp says the oil/gas ratio is at an all-time low and it has great significance; the other camp says that oil and gas have different markets, are used in different products and cannot be compared.

The author's "squiggle chart" looks like the night's walking path of the town drunk. It's hard to argue that oil and gas have any sort of relationship at all.

Sep 02 10:57 AM

[Not Jerry A...:]

Sell UNG calls buy nat gas futures if ur going to play nat gas...UNG is doomed as long as the premium is near 20% regardless...they need to be able to issue new shares...when governments change rules and regulations things get all out of wack...(i.e. when the short selling ban was in place - how many quant funds closed shop?)

Sep 02 12:20 PM

[Jack Walker:]

Donald,

An alternative to consider is perhaps crude oil has been bid higher by index speculation and it will decline returning the Crude Oil – Natural Gas ratio to its normal range.

Frontline estimates around 50 VLCCs are being utilized as storage facilities. This seems to be more related to futures market term structure arbitrage and less to producer and user supply and demand fundamentals.

Is it possible crude oil will be the one to correct?

Jack

Sep 02 01:12 PM

[The Greates...:]

NG will only be used when the oil industry allow's it to.

Sep 02 10:48 PM