So many extraordinary things happened in 2008: back-to-back monthly record mutual fund withdrawals, extreme currency dislocations, and crazy stock price volatility, just to name a few. Yet while most of us were glad to leave the Year of the Black Swan behind, I think I've spotted another blackbird in the relationship between oil and natural gas.
At a fundamental level, different forms of energy should be fungible. Oil, natural gas, coal, and other fuels all produce a certain amount of energy. Moreover, with varying degrees of difficulty, you can often turn one energy commodity into another, or substitute between the two in various applications. For instance, you can make diesel fuel and natural gas from coal, or you can choose a furnace that runs on heating oil or natural gas. These facts should tie energy prices of different commodities to each other, which is why the recent relationship between oil and natural gas boggles the mind.
A statistical outlier
Between 2001 and 2008, the ratio of the price of oil to the price of natural gas stayed roughly between 6 and 15. Ordinarily, things like cold snaps and other weather-related phenomena, as well as supply issues, can push one commodity's price higher relative to the other.
But recently, the ratio of the front-month contracts of oil and natural gas rose to over 27. By my calculations, that qualifies as an extremely rare six-sigma event based on past moves in the oil-to-gas ratio. The conclusion here is that either natural gas will rally, or oil will sell off, or both. Whatever the combination, statistically, natural gas is in uncharted territory relative to oil.
Why is this happening?
There are plenty of theories as to why oil and gas have moved out of lockstep. Huge gas finds from shale have driven supply upward to the point where available storage is almost full. But many sources of energy consumption, such as autos, still rely almost entirely on oil. While Honda (NYSE: HMC ) already has a natural-gas powered car and Toyota (NYSE: TM ) has announced plans to develop a natural-gas hybrid vehicle, converting many forms of oil-based consumption to natural gas will take time, suppressing demand during the switchover.
In addition, energy speculation may play a role. Recently, the government has again called for ways to limit speculators using energy futures. Yet while some point to higher oil prices in recent months as evidence of speculation, the gas market certainly shows a different picture. If anything, the opposite seems to be true with natural gas: The U.S. Natural Gas ETF (NYSE: UNG ) is currently priced at almost a 10% premium to natural gas positions it holds, and it has chosen not to issue new shares in light of worries that new regulation will make it impossible for the ETF to meet its investment objective.
Natural gas is more difficult to store than oil and much more difficult to move around. For the most part, unless you have an expensive pipeline, there isn't much you can do when demand is weak. As of the end of August, natural gas futures had dropped 47% in 2009 as the worst economic slowdown since the Great Depression cut factory and power-generation demand, which resulted in record stockpiles.
Supply and demand inevitably pull back into equilibrium, though. The number of drilling rigs has fallen 56% from last year's peak, and the economy seems to be stabilizing.
That may explain why stocks of natural gas producers have already rallied even before we've seen any big improvement in natural gas prices. Anadarko (NYSE: APC ) , XTO Energy (NYSE: XTO ) , and Chesapeake Energy (NYSE: CHK ) have all done quite well since the March lows. Meanwhile, more diversified energy producers like ConocoPhillips (NYSE: COP ) haven't done nearly as well, suggesting that some believe oil prices will need to fall to bring the oil-to-gas price ratio back in line.
The extreme relationship between oil and natural gas is likely to resolve itself soon. As I see it, stocks with natural gas exposure should continue to do well as prices get back in line.
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