Mean Reversion In Energy

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Includes: BGR, BNO, BOIL, DBE, DBO, DCNG, DDG, DGAZ, DIG, DNO, DRIP, DTO, DUG, DWTI, ERX, ERY, FCG, FENY, FIF, FXN, GASL, GAZ, GUSH, IEO, IYE, JJE, KOLD, NDP, OIH, OIL, OLEM, OLO, ONG, PXE, PXJ, RJN, RYE, SCO, SZO, UBN, UCO, UGAZ, UHN, UNG, UNL, USL, USO, UWTI, VDE, XLE, XOP
by: Andrew Hecht

Summary

Ugly crude oil.

Ugly natural gas.

Crude oil versus natural gas.

A correction of long-term divergence.

Volatility ahead.

One of the best tools to determine the real and current value of an asset is the inter-commodity spread. The current price of a stock, bond, currency or commodity is always at our fingertips in real time but understanding value can often be an entirely different matter. An inter-commodity spread is the price differential between one commodity or asset and another. Using these types of comparisons, a completely new world of understanding often emerges. This is particularly true when one delves into the historical price relationship between the two.

Inter-commodity spreads shed the best light on value when the two raw materials are related and when one can be a substitute for the other. In the energy sector, price action in two commodities over recent months has resulted in a dramatic reversion to the mean. In other words, the prices of the two commodities have returned to levels where they had been on a historical basis after an extended period of divergence.

Ugly Crude Oil

oil Prices of energy commodities have plunged over the past year. It all started in 2014. The action in the oil market has been front and center for months. The aftermath of each of the last three OPEC meetings has been a new multi-year low. Since June 2015, the price of NYMEX crude oil has dropped from over $107 to under $30 per barrel. The decrease of over 70% has weighed heavily on markets across all asset classes.

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The monthly chart of NYMEX active month crude oil futures highlights just how ugly this energy market has been. The active month February NYMEX contract settled at $29.42 per barrel last Friday, the lowest level since 2003.

The price of Brent crude oil has dropped even more over the period. Brent was trading at a healthy premium to NYMEX crude oil back in 2014; this past week the now active month March Brent crude oil fell to a $1.45 discount to March WTI NYMEX crude. A combination of increasing Iranian sales and U.S. exports has shifted the structure of the crude market. Oil product prices remain at the lowest levels in years, and term structure in both WTI and Brent crude is in wide contango signaling that the world continues to be awash in oil. Fundamentals continue to be ugly, even at current low prices. Last week both WTI and Brent crude closed below $30 for the first time in over a decade.

Ugly natural gas

While the price of crude oil has melted, the action in the natural gas market has not been much better. Producers of both energy commodities are reeling. In February 2014, natural gas traded to highs of $6.4930 per mmbtu. A frigid winter caused inventory levels to fall. Since then, stockpiles have built and in late 2015, a warm start to winter caused carnage in the natural gas market. In December, the price fell to the lowest level since the late 1990s when it hit $1.684 per mmbtu. Between February 2014 and December 2015, the price of the energy commodity lost 74% of its value.

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The monthly chart of NYMEX natural gas futures highlights the price depreciation over the period. Natural gas fell to a level that was so low last month that profitable production was nonexistent.

Both of these energy commodities have had serious effects on other markets. There are so many energy companies in major stock indices. At the beginning of 2016, we have seen plenty of selling in equity markets. So many energy companies have borrowed money in debt markets that we have seen a deterioration of the high yield debt market. Additionally, energy is an important cost component for the production of many, if not most, other commodities. Falling energy prices lowers the production cost for other raw materials. In a bear market, this means that producers of metals, minerals and other commodities will continue to sell as lower input costs have lowered the breakeven level. Lower energy prices have created a vicious cycle of selling and there has been nowhere to run to and nowhere to hide. The economic slowdown in China, the world's largest commodity consumer, has resulted in global deflationary pressures.

Crude oil versus natural gas

Crude oil and natural gas are both important energy commodities that power many sectors of the global economy. Almost every business in the U.S. and around the world depends on crude oil and natural gas for the manufacture of their goods as well as transporting them to market. On an individual level, an oil product, heating oil, heats many homes. Gasoline powers the vast majority of automobiles around the world. Natural gas is a key input in the production of power or electricity. Cooling our homes during the summer season depends on natural gas. Additionally, many homes have switched boilers from oil-based energy to natural gas over recent decades. Therefore, both energies have utility all over the globe and in terms of some requirements, in many cases, they are interchangeable or one can serve as a substitute for the other. Therefore, when understanding the current value of each energy commodity, it helps to examine the price relationship each has with the other. Thus, an inter-commodity spread, crude oil divided by the price of natural gas, can shed light on the relative value of each.

A correction of long-term divergence

The price moves in crude oil and natural gas over recent months have served to correct a long-term divergence between the two energy commodities. It turns out that a huge divergence between the two energies developed from 2010 through 2013.

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The monthly chart of the price of active month NYMEX crude oil divided by the price of active month NYMEX natural gas illustrates that in 2012, the divergence hit all-time highs. Since then, the price relationship between the two commodities has moved steadily towards the long-term mean. This trend has continued for the past three years, and in the second half of 2015, it finally fell below the highs of 1990 and back into the long-term normal range.

This is important for two reasons. First and foremost, it highlights how important inter-commodity spreads are in terms of price corrections. Levels that constitute historical mean levels tend to draw prices like a magnet back to those levels after periods of divergence. This is not only applicable to energy markets; it has relevance for other commodities and all asset classes for that matter. The relationship that prices of two substitutable commodities or assets have with one and other tend to revert to the long-term mean over time. Second, it could be telling us that crude oil and natural gas are now at levels that are fair value after a long period of divergence. In other words, low energy prices are with us for a while and it is likely that the two energy commodities will move in a more correlated fashion in the months ahead. This does not mean that these markets will be quiet; it could mean exactly the opposite.

Volatility ahead

At this point, it would be naive to think that the energy markets are going to go to sleep and that volatility is going to die. While it is possible that huge inventories of both natural gas and oil around the world will continue to depress prices, both are likely to go through periods of extreme volatility. In crude oil, the fact that half the world's reserves are located in the Middle East, which is the most turbulent region of the world, means that the lower the price drops the more sensitive it will be to any violence, governmental changes or power shifts in the region. When Saddam Hussein invaded Kuwait in 1990, the price of oil was at $20 per barrel; it doubled in a matter of hours. The same is true for natural gas; a sudden change in weather or natural disaster could cause extreme volatility. In 2005, a hurricane that hit the Gulf Coast of the U.S. briefly lifted the price of over $15 per mmbtu. No one knows what the future holds for these two energy commodities, but the price action over the past year and a half and the current state of the world from both an economic and political standpoint promises volatility is not going away any time soon.

The most important takeaway from the case of the crude oil versus natural gas inter-commodity spread is that a long-term divergence has corrected. The lesson is that divergence leads to opportunity and mean reversion trades are some of the best ways to capitalize on divergence and understand true value when analyzing any market. I have prepared a video on my website Commodix.com which augments this article and provides a more in-depth, detailed analysis on the current state of energy markets to illustrate and highlight the real value implications and opportunities available.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.