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The Gas/Oil Disconnect

By Elliott H. Gue
15 Jun 2006 at 11:04 AM EDT
http://www.resourceinvestor.com/pebble.asp?relid=20714

MCLEAN, VA (EnergyStrategist.com) -- Natural gas is looking very cheap right now relative to oil prices. This is undoubtedly one of the most glaring discrepancies at work in the energy markets today. While oil prices have soared to new highs, natural gas sits at less than half its 2005 top. Check out the chart below.






Source: StockCharts.com

This chart depicts a simple ratio - the price of natural gas divided by the price of oil. When this ratio is falling, gas prices are falling faster than oil prices or rising more slowly; the opposite is true when the ratio is rising.

To better illustrate the long-term trend, I've offered a chart covering 10 years of data. The last time gas prices were this low relative to oil was in late 2001. In addition, we can see two other spikes to these levels on the ratio--one in late 1996 and another in late 1999 to early 2000.

Whenever the ratio gets this extended to the downside, it tends to snap back to a more average level, a process known to statisticians as mean reversion. In many cases, the ratio ultimately shoots way above the long-term average, with natural gas prices becoming stretched relative to oil. This occurred in early 2001 during the California power crisis and again last year in the wake of Hurricane Katrina and the Gulf Coast gas supply disruptions.

I suspect that once again we will ultimately see the gas/oil ratio climb back to a more average level. This mean reversion adjustment can be accomplished in two ways: Oil prices could fall from current levels, and/or natural gas prices could rise. It's interesting to note that on prior downside spikes in this ratio, the latter scenario developed - natural gas prices rallied faster than oil.

Specifically, in late 1999 through the end of 2000, natural gas prices shot up from around $2 per million British thermal units (MMBtu) to nearly $10 per MMBtu, a five-fold increase. Meanwhile, oil prices were essentially flat in the $25 to $36 area throughout this entire period. And in late 1996 gas spiked from $2 to $4.50, while oil moved up from $20 to $25 blue barrel (bbl). Gas more than doubled in this period, while oil rose just 25%. Finally, in late 2001 through early 2003, gas prices also rose faster than oil causing the gas/oil ratio to mean revert.

Catalysts for the Shift

Fundamentally, sentiment on gas is extraordinarily bearish right now because storage levels of gas are so high. Basically, a warm winter meant that demand for electricity was lower than average; this allowed producers to actually build considerable inventories of gas in storage. As my chart below illustrates, inventories of gas are seasonally much higher right now than at any time in the past five years.



Source: Bloomberg

Summer demand for gas is starting to build. As the weather heats up, look for power plants to start burning gas; this will gradually work to reduce the gas glut. Of course, demand will take several weeks to really begin to work through inventories - the adjustment process caused by demand pull will be slow.

But there are other factors that could catalyze a faster reduction in gas inventories. Chief among those would be another major supply disruption in the Gulf of Mexico this year caused by a major hurricane in the region. Forecasters are calling for another busy hurricane season, so this is certainly not an improbable event. Even a few weeks of Gulf supply disruption could result in a major decline in inventories of gas, just as it did last year. Supply disruptions coupled with hot summer weather would have an even greater impact on pricing.

Moreover, I see a price floor for gas near $5 per MMBtu to $5.50 per MMBtu. At around that level, utilities would start cutting back on output from coal plants and rely more heavily on natural gas-fired generation. This is particularly true in light of ever-more-stringent environmental regulations. Such a switch would clearly raise demand for natural gas and put upward pressure on pricing.

And I also suspect that smaller natural gas producers will begin to cut back on production or at least delay projects if gas prices fall much beyond $5 to $5.50 per MMBtu. This, too, could reduce the supply of natural gas in the intermediate term.

Finally, last winter was an aberrantly warm one. It's highly unlikely that the 2006-07 winter will be as warm. Thus, inventory drawdowns late in 2006 could well form another catalyst for gas demand and inventory drawdowns.

It's absolutely impossible to predict which, if any, of these catalysts will come to pass. However, with sentiment so bearish on gas right now and inventories so high, it will not take much bullish news to get gas prices moving once again. And it's hardly a stretch to say that one of these catalysts is likely to emerge during the next six to nine months.

Bottom Line

During the past few months, I've been highlighting the big natural gas/oil discrepancy in The Energy Strategist. In early April, I even compared natural gas and oil prices on a British thermal unit (Btu) basis. Basically, Btus are a measure of energy - we can directly compare the price of energy produced using coal, oil or gas.

The U.S. Energy Information Administration estimates that an average barrel of crude contains 5.8 million Btus of energy; the current cost for that barrel is around $70. But with gas at $6, 5.8 million Btus cost just $34.8. In other words, on an energy equivalent basis, gas is half as cheap as oil. This is unlikely to persist longer term.

During the next six to nine months, I suspect that gas-levered producers will outperform producers levered to oil prices - in the next issue of The Energy Strategist, I'll be looking at ways to play that trend. Moreover, my bullish position on natural gas has ramifications for the shallow-water drilling market in the Gulf of Mexico; I see a major shortage of shallow-water jackup rigs developing in the Gulf later this summer.

Copyright © KCI Communications, Inc. 2006

Elliott H. Gue is Editor of “The Energy Letter.” Click here to sign up for the free bi-weekly newsletter.