Divergence Between Natural Gas and Oil Prices at Extremes

Includes: OIL, UNG, USO
by: FP Trading Desk

The divergence between natural gas and oil prices is at extremes. Oil prices have roughly doubled since early March lows yet natural gas prices continue to fall. This difference in prices has not been this wide since 1990 suggesting a long gas short oil trade, yet is may come from falling oil prices rather rising gas prices.

The number of rotary rigs for drilling natural gas has been cut in half from more than 1600 to less than 800 according to data from Baker Hughes, yet gas stocks continue to rise due to week demand and strong supplies. Industrial demand accounts for nearly one-third of natural gas-deliveries each year reports the EIA and rising supplies from unconventional gas fields such as Barnett Shale in Northeast Texas are upsetting the balance in the market.

Technological advancements including horizontal drilling have led to increased supplies at the expense of prices and hurts the marginal suppliers that dominate the Canadian market says James Cole, portfolio manager at AIC Ltd who remains bearish on the sector. Gas in storage increased again at the end of May and stands at 21.6% above the five year average ending 2008.

Despite the gloomy picture, one analyst thinks that the "seeds" of a natural gas recovery are "germinating" due to spending cutbacks based on weak pricing. Richard Wyman of Cannacord Adams believes that reduced drilling activity will eventually allow bombed out natural gas prices, trading at $3.80/MMBtu down from a high of $14 last year, to recover.

Wyman recommends positions in low-cost operators with strong balance sheets because the timing and magnitude of the recovery is uncertain. Given the sorry state of the market, playing it safe sounds like very good advice.