Oil, as expressed by the United States Oil Fund (NYSEARCA:USO) and natural gas, as expressed by the United States Natural Gas Fund (NYSEARCA:UNG) are long-term substitutes. Oil trades, based on 25 years of data, at approximately double the *energy equivalent price* of natural gas. However, the spot oil price is now approximately six times the spot natural gas price, using energy equivalent prices. This relative cheapness of natural gas relative to oil is unprecedented in 25 years. This may means the long-term relationship has broken down based on new means of natural gas production, but I suspect there is a fundamental case for gas to outperform oil on a medium term basis.

Now, that does not mean oil will fall and/or natural gas will rise overnight, for example see here for a broadly similar argument made in 2009 which is no less valid than this one, but has been 'wrong' for 3 years. However, the fundamentals of the argument appear to remain valid, and in recent weeks gas is starting to outperform oil.

**What do energy equivalent prices mean?**

The core concept here is energy equivalent prices so it is worth taking a moment to explain what this means. Energy equivalent prices are based on the fact that oil and gas both produce energy, and we can compare their prices on that basis.

In order to get the same energy from gas as a barrel of oil you must burn 5,800 cubic feet of natural gas. Therefore, since oil prices are typically quoted in thousands of cubic feet, multiplying the natural gas price by 5.8 gives you the same energy value from the natural gas as you would obtain from a barrel of oil. By performing this calculation, we have stated oil and natural gas in energy equivalent terms and can compare the two prices, because, in theory, if your goal is to produce energy then you should be indifferent as to whether you obtain it from oil or gas.

**Substitutability of oil and gas and its limitations**

In the long run, all fuels are substitutes. You can burn any one of them to obtain energy. Of course, in the short run, there's significant friction, because, for example, a power plant is set up to use oil or natural gas and switching to an alternative fuel requires significant capital expenditure and contractual changes. And, indeed power plants are one of the better examples of substitution, switching, for example, a car from oil to natural gas is a much trickier proposition.

In addition, transportation and storage costs differ between the two fuels which create frictions that prevent price equality between them. Nonetheless, despite a host of meaningful real world caveats, there is a robust economic principle that suggests that different fuels should very roughly trade at similar levels to each other. Of course, there a host of caveats and constraints to this, but at the most basic level there is a powerful and fundamental relationship. For example, all else equal, increased natural gas production should mean that over the long term all hydrocarbons fall in value, not that just natural gas falls in value.

**The mathematical detail**

One barrel of oil is roughly equivalent to 5,800 cubic feet of natural gas in terms of the energy generated. Therefore, you can either multiply the gas price by 5.8 to get the equivalent oil price, or divide the oil price by 5.8 to get the gas price. Here I standardize the natural gas price relative to the oil price. So if the gas price is $1.00 (as it's conventionally quoted per MMBTU, I'm used simple illustrative numbers here), then the natural gas price "should" be $5.80 per barrel. I use "should" because the both oil and gas would then be priced the same for the amount of energy they both produce. In this example, if the oil price is greater than $5.80 per barrel then it's expensive relative to gas and if it's less than $5.80 then oil is cheap relative to gas.

**The energy equivalent price history**

Now let's look at the history of both oil (spot West Texas Intermediate) and gas prices (spot US wellhead prices) since 1985...

**Ratio of oil to natural gas prices in equivalent energy terms**

0%=equal pricing between oil and gas on an energy equivalent price basis (for values greater than 0%, oil is more expensive than gas)

1985-present (monthly)

source: EIA

and here's the data for the past 5 years, to make the recent history easier to see.

**And here's the same data as a probability distribution basis**

*This basically shows that most of the time over the past 25 years, the oil price has been 50% to 150% more expensive than natural gas on an energy equivalent basis.*

*y axis=historical observed probability (past 25 years), % of the time when oil has been this % more expensive than natural gas*

*x axis= ratio of oil to gas price (1=oil 100% more expensive than gas on energy equivalent basis, 2=200%, 3=300% etc.)*

Source: EIA

**Conclusion**

This trade of owning natural gas through a vehicle, such as UNG, and not owning and/or shorting crude oil through a vehicle, such as USO, may take years to play out. However, investors should expect natural gas to outperform oil on a long term basis if history backed by elementary economics is any guide. Indeed, with the relative valuations between the two now well away from historical norms this presents an opportunity for the long term oriented investor.

Alternatively, aside from investing the commodity directly, investors may consider companies with significant gas assets such as WPX Energy (NYSE:WPX) or Chesapeake Energy (NYSE:CHK).

**Risks**

The main risk here is finessing the timing, and the words of the economist John Maynard Keynes are apt that "in the long term we're all dead" and indeed "the markets can remain irrational longer than you can remain solvent".

In addition, the fact that on average for the past 25 years the oil price is +105% more than the natural gas price suggests that the relationship between the two is not as clear cut as pure substitution would suggest, or the average premium would have been 0%.

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