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Oil-to-Gas Ratio

If oil and natural gas were perfect substitutes in all aspects of their usage, market forces would be expected to force their prices to divulge and be equal on an energy-equivalent basis. One barrel of West Texas Intermediate (WTI) crude oil has an energy content of approximately 5.8 million btu. The pricing of natural gas (at the Henry Hub), in contrast, generally is denominated in 1 million btu. Therefore, if the market prices of the two fuels were equal on the basis of their energy contents, the ratio of crude oil prices to natural gas prices (the Henry Hub) would be approximately 6.0.

The crude oil market is an international market, whereas the U.S. natural gas market is confined primarily to North America. The costs and methods of transporting oil and natural gas are significantly different.

Therefore, the crude oil-natural gas ratio traded has historically remained between 8-to-12.

The recent trend

Since the beginning of 2009, the ratio has witnessed a drastic surge due to rising oil prices and declining natural gas prices.

The prices of crude oil witnessed an increase, primarily due to tensions in the Middle Eastern and North African (MENA) regions, which have been conflict zones ever since the rise of the Arab spring, which resulted in supply disruptions. Prices increased further after economic sanctions were imposed on Iran for its non-cooperation on the nuclear issue.

On the other hand, the boom in production of shale natural gas has caused an oversupply in local markets, which has depressed natural gas prices in the local market, forcing them to trade below $2 per MMBTU for the Henry Hub spot in April 2012. The ratio peaked at 60:1 for Brent and 52:1 for WTI.

Source: EIA.

Recent Reversal towards normalization

Since then, the prices of crude oil have eased and are down approximately 24% and 25% for WTI and Brent, now trading at $79.39 per barrel and $89.49 per barrel. The prices of natural gas, on the other hand, have increased about 26% to trade at $2.50 per MMBTU for Henry Hub spot, bringing the ratio down to 31.8 and 35.8 for WTI and Brent; these levels are still much higher than the historical averages.

Natural gas production

Natural gas production has remained relatively flat during the period extending October 2011 to March 2012, due to the oversupply of natural gas, while the preliminary data showed that production declined slightly in March.

Price forecast

The forecast prices of WTI, Brent and natural gas are $99/bbl, $105/bbl and $4.00/MMBTU for 1Q2013, according to analysts at J.P. Morgan Chase.

Will mean reversion take place?

The low natural gas prices have opposite implications for producers and consumers. As witnessed in the past, producers of unconventional natural gas are shifting their production from natural gas to oil and liquid plays, due to the better pricing. At the same time, consumers have started to shift their consumption towards the cheaper available fuel (natural gas).

The opposite shift in preferences for natural gas and oil is expected to continue and we are of the opinion that going forward, the crude oil-natural gas ratio may witness mean reversion to some extent. However, the ratio may not completely reverse to previous levels due to the abundance of the cheap natural gas available domestically.

To benefit from the expected increase in natural gas prices, one should go long the Natural Gas ETF (NYSEARCA:UNG). However, shorting the OIL ETF (NYSEARCA:USO) should only be done if the global economic situation worsens going forward.

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

Source: Will Oil-To-Gas Ratio Mean Revert?