Friday, August 14, 2009

Thoughts on the Natural Gas and Oil Price Relationship

One of the biggest stories I'm going to be watching for the rest of the year is the performance of natural gas prices, specifically the spot price, which is a close proxy for the wellhead price that royalty owners see. The producers talk a lot about their price hedges, but they don't flow "upstream" so they are of no benefit to the property owner. As a result, I rarely talk about hedges in this space.

There is much speculation, especially from financial types, that natgas prices will be in the $6/MMBtu range by the end of 2009. This is based on everything from the price of futures contracts, the relationship between natgas and oil prices and the expected reduction of natgas production (mostly because of decreased rig counts). A year ago I would have been disappointed by $6 but at the current price of below $3.50, but...

This week's Energy Information Agency data came out and showed the total amount of gas in storage increase to 3.152 trillion cubic feet, 19.6% above the five-year average and 23.1% above last year's level. The price chart, below, shows that natgas prices have been steady for quite a while. It also shows that the oil price equivalent per MMbtu is now triple that of natural gas. The second table shows wellhead prices over the past six months.

Much has been said about the growing spread in the ratio between gas and oil prices, and many people believe that this divergence will cause natgas prices to increase to correct the gap. Looking at it as an outsider, however, I believe that reasoning behind this suggestion is faulty. The basic assumption by many is that the prices will move back together to harmonize with long-term historical trends, but I believe that the relationship between the two commodities is much more complicated than that in the short-term. The drivers of the two commodities are different, and the global economic downturn has exacerbated these disparities.

Oil and natural gas have different basic uses: oil mostly is a transportation fuel, while natgas powers electrical plants, industry and homes. Therefore in practical application they are not readily substitutable. If oil prices spike, we can't flip a switch and use natgas to power our cars (until T. Boone Pickens gets his way). Oil is a worldwide commodity and is shipped all over the globe from a few dominant sources. Because it is mostly transported by pipeline, gas tends to be a regional fuel with regional pricing dynamics. LNG tankers will help spread the fuel to a greater audience, but that doesn't change the fact that in the U.S. natural gas is mostly a domestic product (remember I'm only concerned with U.S. wellhead prices).

Because of the North American supply/demand dynamics and the fact that natgas is not readily substitutable with oil, I believe the price of gas is independent from that of oil and its short-term recovery is almost entirely dependent on the improvement of the U.S. economy. It will not be a self-healing situation to catch up to the price of oil. Sure, hurricanes and the actions of commodities and futures traders will make an impact, but the economy is the fundamental driver. Almost everything else is noise.

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