The Price Link Between Crude Oil and Natural Gas Is Disappearing

Includes: UNG, USO, UUP
by: Valerie Wood

Historically, the price of oil and natural gas commodities has moved in tandem because the demand for both commodities will move up or down in conjunction with the economy and weather.

As a result, over time, analysts have placed a value on what level natural gas prices should be at if crude oil is at a certain price level. This is referred to as the oil-to-gas price ratio and this ratio has become a way of measuring if the value of each of these commodities is too high or too low.

The historical oil-to-gas price ratio has ranged from 6:1 to 10:1. For example, at a 10:1 ratio, if the price of natural gas is $7 per MMBtu, then the value or price per barrel of crude oil is expected to be around $70 per barrel. This oil-to-gas price ratio will move up and down based on current events, particularly if there is political unrest. But on average, it has ranged from 6:1 to 10:1.

However, the oil-to-gas price ratio changed dramatically in the middle of 2009. As crude oil climbed to over $80 per barrel, natural gas NYMEX prices fell to $4 per MMBtu, taking the oil-to-gas price ratio to 20:1. There are two ways to look at this ratio relative to history. Some may say that at $4 per MMBtu, natural gas was undervalued and should rise to bring the price ratio back into balance. Others may say that at $80 per barrel, crude oil was overvalued and should decline to bring this ratio back into balance. Basically, in 2009, one of these commodities was expected to move up or down to return the 20:1 ratio to something closer to historical levels of 6:1 to 10:1. But that didn’t happen.

Because of the wide price ratios last summer, some investment companies urged investors to buy natural gas commodities based solely on this ratio, under the belief that it would ultimately return to a historical level of 6:1 to 10:1, providing investors with a formidable profit. Under the oil-to-gas price ratio argument, investors anxious to earn a quick buck presumed natural gas was just too inexpensive in comparison to oil. To their surprise and dismay, those who took that bet did not profit because the oil-to-gas price ratio did not return to historical levels.

For all practical purposes, the prices of crude oil and natural gas are not really related and are not easily interchangeable today. Historically, there was more of a link. About fifteen years ago there was a greater number of older power-generation facilities that could switch back and forth between oil and natural gas, and fuel-switching between the commodities could impact the price of each commodity.

Today, transportation accounts for 70 percent of U.S. oil consumption, while natural gas is primarily used for heating, power generation and industrial processes. Fuel switching by power generators has declined substantially, and the ability to switch fuels in response to short-term price signals no longer exists.

Overall, crude oil often acts as a proxy for energy demand. Historically, another reason why the two commodities moved in tandem was because investors tended to buy “energy commodities,” which may have included both crude oil and natural gas. Thus, it was often said that natural gas moved in sympathy with crude oil prices.

However, the chart below shows that relationship has wavered over the past year and is not nearly as consistent as it was in 2007 and 2008.

Question: Will the crude oil to natural gas price ratio return to historical levels?

Conclusion: No, although at times the historical ratio will seem to apply, if only by coincidence.

Support for Conclusion: The concept of a crude oil to natural gas price ratio continued to exist long after fuel switching was really no longer an issue, because speculative investors looked at the historical ratio as a profit-making opportunity. Basically, the natural gas supply situation has changed dramatically over the past two years. With the rapid expansion of shale supplies and worldwide expansion of liquefied natural gas, investors looking to make a profit by relying on the historical crude oil to natural gas price ratio are more likely to get burned. As investors learn this lesson, this historical ratio will become a thing of the past.

Disclosure: Author is bearish on natural gas