A simple analysis of Crude and natural gas prices over the years would depict that these two energy sources have generally traded within a specific range when measured in relative terms with certain periods of divergences as exceptions.

When we look at Natural gas as just another source of energy substituting crude demand then the rule of thumb says that natural gas prices should be driven by and closely linked to Crude prices. However, given that both these energy sources use different pricing conventions the best way to compare these would be to first bring them on a common measurement platform and look at their relative price. Crude (WTI) is measured in barrels and Natural gas (Henry Hub) is measured in MMBtu, wherein a barrel of crude energy equivalent would be approximately 5.8 MMBtu of natural gas. In other words, crude prices should hover around 5.8 times the natural gas prices i.e. based on this multiple with natural gas (Henry Hub) trading at USD 10/MMBtu, the Crude (WTI) prices should be around USD 58/bl. However, an analysis of the natural gas and crude prices over the past two decades confirms that this has not been the case. Crude has generally traded at a premium with the average multiple being much higher around 9.6 times natural gas prices. This premium is primarily due to wider use of crude over natural gas as well as other factors in favor of Crude such as ease of supply; ease of inventory storage; and a presence of a unified body such as OPEC which keeps a check on unusual drop in crude prices by way of controlling the supply

Natural gas pricing mechanism and the structural shift:
A very long-term historical analysis of these two commodities reveals that in US natural gas and crude have acted as close substitutes with natural gas prices closely tracking the oil prices. This can be traced back to the prevalence of dual powered industrial and electrical power generators, which left room for swapping to the cheaper commodity, whenever it turned undervalued. However, over the years, especially in the past two decades the dwindling number of such dual powered facilities has led to huge divergences in the general price relationship.

While oil prices is one of the major determinants of natural gas prices, it’s the shortage of these facilities to switch from one fuel type to the other that generally brings into picture the other dynamics, such as seasonality, extreme weather fluctuations, natural gas inventories as well as supply/production disruptions.

How does Seasonality affect the Crude/Natural Gas relationship?
The premium that crude trades at over natural gas generally narrows down during the winter months in US. This can be attributable to the fact that the natural gas prices generally tends to be higher during these winter months due to the higher demand for heating equipment. Coincidentally, oil demand and prices tend to be softer during these months given the closure of most US refineries under their annual maintenance programs.

On a structural basis the supply markets and inventories stand out as the major determinants of natural gas prices apart from their linkage to the oil prices. The current inventory levels undermine natural gas’ prices relative to oil going forward. As per EIA, US, currently, sits on a crude inventory for 24 years, while current natural gas inventories represent as high as 70 years’ domestic consumption demand. Moreover, given the fact that the US is Natural gas-rich, the marginal cost of production going forward is expected to stay subdued. Although the current estimated cost of production is an incentive for demand switch in favor of natural gas in the US, as per EIA the costs are not low enough for the global market to support a broad-based shift in favor of natural gas.

Furthermore, the constraints in substituting natural gas for oil would also cap the natural gas demand going forward. Substitution in sectors like residential, commercial, and electric power sectors would not be of much difference given the low contribution of these sectors to the total fuel consumption. Moreover in industrial sectors, which contribute to a major portion of the overall fuel consumption, there are many operational hindrances to a switch to natural gas as primary fuel source.

What drives natural gas prices apart from oil prices or rather what led to their apparent disconnect in recent terms?
Since 2Q09, the relationship started deviating from the historical norm to a noticeable extent. The ratio shot up to an unforeseen level as it topped 30 by the 4Q09. In fact between June ‘09 and November ‘09 the ratio averaged 22. This deviation was on account of strong recovery in crude prices from its lows and on the other hand weakness in natural gas prices. In fact, such was rally in crude prices that in first three quarters of 2009, the commodity appreciated by almost 138% after bottoming out in late ‘08; comparably natural gas underperformed crude with a relatively meager 78 % appreciation.

The answer to this again lies in the demand-supply fundamentals of both these commodities. First of all, crude oil derives its demand curve from higher number of variables than natural gas does. To further elaborate, oil has a global consumption base, which is supported by strong logistics which make consumption of crude in any part of the world possible. So, the natural gas demand is grossly concentrated in the developed world. What’s adding to the woes of natural gas market is that the current recovery is being driven by strong growth in developing economies, while developed economies are lagging behind on economic growth terms.

The supply side also explains the phenomenon to a large extent. The robust rally in energy prices, which preceded the correction, provided a strong incentive to increase the exploration and production of oil and natural gas. This created a huge supply glut, and though the supply concerns eased out for crude due to a stronger and diversified demand base, natural gas continues to see inventories at record levels.

Road ahead for the natural gas/crude relative metric?
Going forward, the above mentioned factors would continue to determine the course of relationship between the two commodities. However, as per the EIA, in a low oil price scenario the ratio is going to average 7.7 between 2009 through 2030, while it is expected to average 14.6 and 20.2 in the base case and high oil price scenario, respectively.

This entry was posted on Wednesday, January 13th, 2010 at 4:47 am and is filed under SGA Knowledge. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.