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Sven T.
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Sven Taylor is an avid entreprenuer and investor. Mr. Taylor started and ran several successful businesses ranging from an auto rental franchise to a lithographic printing retailer. Currently, he serves as portfolio manager for Ten Talents Capital Management, llc and is a principal with the... More
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  • Natural Gas to Oil: A More Accurate Ratio 0 comments
    Apr 21, 2010 7:08 AM | about stocks: UNG, OLO

    As investors in commodity-related stocks are well aware, Natural Gas is trading far below the traditional parity level with Oil.  Many traders and investors have entered the market long on Natty and they have been frustrated to watch the spread actually worsen over the past several months.  Pundits are questioning whether or not parity actually exists between the two fuels.  Here on Seeking Alpha, there have been a number of comments and posts arguing that an NG to WTI ratio is unreliable.  Folks, this is not a new argument.

    A few years ago, investors were having the exact same discussion, albeit with one major difference: in 2005, NG was trading at a fairly large premium over what the ratios would predict.  (The charts below are excerpted from an article by Stephen Brown at the Federal Reserve Bank in Dallas.  Mr Brown's article here)

    Chart 1: Acutal and implied natural gas prices using 10-to-1 and 6-to-1 rules of thumb

    Mr. Brown's point is still valid today.  A macroeconomic relationship does exist because these fuels can serve as substitutes for each other.  But price relationships are complex.  Too complex to be reduced to simple rules of thumb.  Consider:

    1. Oil is more easy to transport than gas. Variance in cost of transport must be factored into any analysis.
    2. Oil price is determined by worldwide demand while gas is heavily regional.  This adds several variables into gas prices that do not necessarily affect oil prices.
    3. It is difficult to determine exactly how easy is it to switch between fuels.  The Department of Energy (DOE) has tried to estimate how much industrial interchange is possible.  Estimates range from 5% (boilers which operate on both fuels) to 20% (dual fired boilers).  This are guesstimates at best.  Analysts at the DOE admit that they cannot measure how many consumers are able to switch fuels by simply switching from a single-fired burner of one fuel to that of another.
    So, if a fixed ratio does not work, what does? The answer is a stochastic ratio that compares the rate of change between the two prices.  Using the more sophisticated ratio yields more accurate results.

    Chart 2: Actual and implied natural gas prices using burner-tip parity and fitted values

    An investor using this method can make arbitrage plays with a fair degree of confidence but it should be noted that it typically takes more than 1 year before the trade can be closed. 

    So buyer beware: a play on natural gas is not likely to pull in a quick buck.

    Disclosure: Long UNG
    Stocks: UNG, OLO
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