Will The Divergence Between Gas And Oil Finally Come To An End?

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 |  Includes: GAZ, GAZC, OIL, USO
by: The Value Investor

Gas prices continued to tumble Wednesday trading briefly under $2 for 1,000 cubic feet, the lowest point since 2002 when natural gas futures hit $1.92

The short term reasons for the price decline (prices fell some 60% since the peak of $4.85 last summer) are obviously the soft winter which led to ballooning inventory levels. However, this is by far not the only reason as structural changes in energy markets have led to a continued decline in gas prices from peak levels around $13/mcf in 2008 to a mere $2/mcf at the moment. At the same time, oil prices have recovered from recession levels to prices in triple digits, causing the oil to gas price ratio to peak at an historical incredible 50 times!

Economic theory dictates that substitution would end such a divergence and lead to a convergent move. However, some elements in the energy market have structurally changed allowing the ratio to run away out of control so far.

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Courtesy of St. Louis Fed

Reasons for the continued price decline

Shale gas

Besides the warm winter season, a longer term development is putting pressure on gas prices. This is the development of shale gas production over the last years. When gas prices peaked around $13/mcf in 2008 a national drilling boom took place. In 2008 alone, the number of completed natural gas wells across the country came in at 33,000 which halved to about 16,000 in 2011 as prices continued to fall (according to the EIA). Despite a 50% decline in the number of gas wells installed, total production rose from 20 trillion cubic feet in 2008 to 22.5 billion last year. Continued advances technology allows the US to ramp up production even further in the future, if needed.

Higher oil prices

An underestimated impact is the increase in oil prices. With oil prices rising absolutely, but also relative to gas, more and more energy producers focus on exploration and production of the black gold. Over the period between 2008 and 2011 the number of oil wells increased from 15,000 to 22,000 per year (According to the EIA). An important fact is that most oil wells simultaneously produce a lot of gas. Producers try to make a profit selling their oil and sell gas as a by-product, irrelevant of the selling price. In similar fashion, natural gas is also a by-product in the drilling of ethane and other resources.

Producers not willing to cut down capacity

Focused natural gas producers are not willing to cut down their natural gas production significantly. This would mean a recognition of massive losses on investments made during the boom years of 2008. This could result in massive write-downs of investments and possibly to financial difficulties for some pure players.

Another reason to not cut production is the simple fact that many producers would violate the lease terms on their land rights acquired during the boom. During those years producers paid as much as $30k per acre under the condition that drilling wells needed to be completed within four year.

While there is clearly abundant supply in the market, partially caused by distorted market conditions due to long term lease contracts, but also the fact that natural gas is a common by-product in production, there are some developments which could trigger a recovery in natural gas prices which will be discussed next.

Possible reasons for a recovery

Shale gas

The impact of shale gas on the industry has been enormous. In just a couple of years, the share in total gas production rose to 25% with proponents being enthusiastic about the security of supplies, the lower production costs and the fact that it would help the US policy goal of energy independence. However, many environmentalists point out that methane used in the production process could leak into groundwater, landscapes are getting polluted and earthquakes near production areas are occurring more frequently and are larger in their magnitude. A dramatic event involving a major environmental spill or a medium-sized earthquake could change the friendly policy towards the industry rather quickly.

End the of an export ban

An important decision could be made by President Obama allowing US gas producers to export their abundant gas supplies to European countries and Japan were they could sell their gas at $10/mcf, roughly fivefold its domestic price. Furthermore this could increase employment in the US, raise tax revenues and help to improve the trade balance. While many natural gas producers are in favor of such a decision, large energy users such as Alcoa (NYSE:AA), which operates in a energy-intensive industry, are lobbying against such an export allowance.

Substitution

With an efficient energy infrastructure, large price deviations between natural gas and oil could be naturally "arbitraged" away by end users.

Major end users such as power plants have already made the switch to natural gas, as far as possible. However, there are more substitution availabilities. With gasoline around $4 per gallon, transportation companies are building in compressed gas tanks in their trucks as payback time for the investments have fallen to less than one year. Furthermore, gas infrastructure on key transportation roads (such as Los Angeles - Las Vegas) is already in place.

Additionally, substitution could take place in the petrochemical industry, which is highly energy-intensive. A lot of these production processes could run on natural gas and a report by ConocoPhillips (NYSE:COP) suggest that US energy companies could invest some $30 billion in development of these industries over the next five years.

Trigger point

It will be hard to estimate when exactly the turning point will be in time and price, but absolute prices leave little room for rock bottom. While a single dramatic event could cause an immediate jump in gas prices, it is more likely that a combination of reduced supply and increased demand will gradually let natural gas prices return to "normal" equilibrium levels.

It is the fundamental law of economics who dictate, but after a "bubble" with prices reaching $13/mcf it just might take a while.

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