Oil and Natural Gas: Why Has This Historical Correlation Recently Broken Down?

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Includes: GAZ, SZO
by: Christopher Waller

The prices of oil and natural gas have always been historically correlated, as the two resources are substitutes for each other. However, this relationship seems to have broken down recently. Why is this and how should investors react? I will offer several possibilities below.
The chart above was created using data from U.S. Energy Information Administration. It shows the relative changes in the prices of oil and natural gas since January 1986 and March 2011 (the earliest and latest dates when data was available for both).

Looking at this chart, we can see that both oil and natural gas have generally moved in the same direction up until recently. Furthermore, previous large deviations have been caused by ‘acts of god’ such as war or extreme weather. Let us look at the correlation between oil and natural gas prices in greater detail:

click to enlarge
Click to enlarge

As this shows, oil and natural gas have historically had a high correlation of 0.8017. The current (March) position is highlighted by the red dot. As can be seen, it has currently deviated significantly from the historical mean. From the chart below, we can see that this is actually historically the greatest deviation:Click to enlarge
In January 1986, the prices of oil and natural gas were $22.93/barrel and $2.28/000s cubic feet, respectively. This gives a price ratio of 10.06. The chart above shows how this has changed since. As can be seen, the price ratio is currently (March) at a historic high of 26.37. This is even greater than the ratio achieved during the Persian Gulf War, the last great oil shock.

Investors now face two questions. First, is this deviation the beginning of some ‘new paradigm’, or will a return to the mean occur? Secondly, if a readjustment does occur will it be through a fall in oil prices, a rise in natural gas prices, or both?

The most obvious explanation is that the recent rise in oil prices has been caused by the crisis in the Middle East. If investors believe that this is simply a ‘shock’ and that prices will fall back then they should short oil, possibly through purchasing the SZO ETF. However, many people now believe that $100+ oil is here to stay. If this is the case, then why hasn’t natural gas followed it upwards?

One explanation is the innovations in technologies extracting natural gas from shale. Whether this has actually increased output or not, it seems clear that the cost of producing natural gas is now lower than ever. In basic economic terms, this has led to an expansionary shift in supply. Given a constant demand, this reduces the price. The only realistic force that can correct this is a fundamental shift in demand from oil to natural gas.

One way this could occur is from the prospect of a rise in the price of oil, as predicted by ‘Peak Oil’, leading to a fundamental shift towards its substitute, natural gas. Investors could therefore benefit from purchasing the GAZ ETF. Alternatively, governments could begin to introduce measures that simply move economies away from oil. Barack Obama, for example, has already spoken about weaning America off oil.

Finally, the cause of this relative change should be the determining factor in an investor’s decision. A simpler strategy could be to simply go long on natural gas through GAZ and short on oil through SZO, thus simply hoping to arbitrage the historic price difference. Nevertheless, the fundamental question remains: are we in a new era for oil and natural gas?

Disclosure: I am long the leveraged Natural Gas ETF LNGA.