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Due to the recent Middle East unrest, crude oil and natural gas have become even more dislocated. As of the time of this writing, crude oil is trading around $99/barrel, while natural gas is trading at $3.842/mmbtu.

From a strictly scientific standpoint, 1 barrel of crude oil should cost about 5.8 times 1 mmbtu of natural gas, because 1 barrel of crude oil has 5.8x as much energy content as 1 mmbtu of natural gas. However, for various reasons, this ratio does not hold true. The natural gas lobby in Washington is not very popular, so even though the US could be thought of as the "Saudi Arabia of Natural Gas," our country does not really support it for political reasons. Instead, our politicians support coal and continued oil usage, while publicly claiming they want to end our dependence on foreign oil. If there was real initiative, the US could be completely energy independent, but this digresses from our real goal: analyzing macroeconomic trends to make sound investments.

The Crude Oil Natural Gas Ratio

The chart below shows the ratio of crude oil to natural gas in white, and the price of natural gas in amber.

Crude to Natural Gas Ratio Chart

(Click charts to enlarge)

As can be seen, aside from a brief return to reality in late 2008, from about mid-2007 onwards, the ratio of crude oil to natural gas has been extremely high. Natural gas is pretty much the only commodity in the world that has not recovered since the 2008 financial crisis, and it trades at about the same levels it traded at in 2002.

A large reason for crude oil's outperformance is due to the global nature of the crude oil market vs. the domestic natural gas market. Since crude oil is a much more international market, it receives the same bid that precious metals receive as an inflation hedge. This phenomenon can be seen when considering that institutional investors typically allocate 1% of their portfolios to crude oil, but none to natural gas.

The last time the ratio was this high was September 2009, and natural gas proceeded to rally 138% until the end of 2009. While much of this was due to the front month expiration and contango in the natural gas curve, one still could have made 68% being long the front month contract and rolling it over each month.

Historical Comparison

Historical Crude to Natural Gas Ratio Chart

The chart above shows statistics on the ratio between natural gas and crude oil over the last 21 years. As can be seen, the highest ratio seen was 26.35 in late August 2009. The ratio as it currently stands is 26.11.

Additionally, the current reading is in the 99.82nd percentile of readings over the last 21 years, meaning that it is almost the highest reading ever seen. Considering that the median reading was 9.02, the current ratio stands almost 200% higher than the median.

CFTC Commitment of Traders Report

The chart below shows the Managed Money net short position over the last 5 years.

Managed Money Net Short Natural Gas Chart

As can be seen, the amount of net shorts from Managed Money has increased drastically in the past month to a current reading of 173,434 net short contracts. This reading is in the 5th percentile of readings over the last 5 years, and almost twice the median.

Because so many traders are short natural gas, any sustained rally off the bottom should trigger extensive short-covering. This would make a rally of 10-20% not out of the question.

Trade Recommendation

Usually when witnessing this large a disparity, I would recommend a trade to short the perceived overvalued commodity and go long the undervalued. However, because I believe in crude oil in the long-term for macro reasons, I would not recommend a short position in crude oil. Rather, I would recommend being long both, but with an overweight bias toward natural gas. Being short crude oil may provide a false sense of security as an inter-commodity spread hedge, but because the 2 commodities trade on entirely different rationales, this is not an appropriate trade.

Our recommendation is to sell puts on natural gas, as well as buy the futures contracts outright if you can stomach the volatility. Because natural gas is such a depressed and volatile commodity, put options on it are expensive, making their sale an attractive risk/reward scenario.

For example, the June 3.65 puts (expiring on May 25th) could be sold for $0.11, or $1,100 per contract. With June natural gas trading at $3.983, this means the trader would keep 100% of the premium collected as long as natural gas does not fall an additional 8.4% in the next 3 months. While 8.4% is by no means a huge cushion, considering natural gas has already fallen 14% for the year, we would think that a floor must be put into natural gas in the near future.

We continue to be short natural gas put options and long natural gas futures, and will add opportunistically on pullbacks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Short crude oil put options, short crude oil call option, short NG put options, long NG futures

Source: Crude Oil to Natural Gas Ratio at Extreme Levels