Oil and Natural Gas: Another Black Swan?

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.

A turnaround
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.

More on natural gas:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Chesapeake Energy is a Motley Fool Inside Value recommendation. The Fool owns shares of Chesapeake Energy and XTO Energy. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.


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  • Report this Comment On September 16, 2009, at 3:11 PM, wolfman225 wrote:

    I don't know if I see the gap closing all that much, at least in the near term. Since we are just now coming into the heating season in the northern tier, I expect oil to hold steady or advance in the coming months. I believe we'll start to see oil futures' price's advance by mid-October. Most private homes rely on heating oil, which is a very close cousin to #2 diesel fuel. This dual demand will help to keep a floor under prices. It will be up to an increase in demand for natural gas to shorten the ratio.

  • Report this Comment On September 16, 2009, at 5:14 PM, aricool wrote:

    I think your article is dangerously over simplistic and not at all rigourous enough to even be taken seriously.

    We're already past the peak of Huricane season, and zero activity. Each day that goes by exponentially drops the risk b/c the chances are already slim that a given huricane would make a hole in one and hit the TX/LA Gulf coast. The last one got completely deflected northward.

    The current pop up is just massive short covering and rabid bull sector rotation desperation. Why can't Nat Gas (NG) go under $2? The factors I talk about below are not priced in now b/c market is controlled now by V-shape recovervy bulls expecting industrial production to go up enough in Q3 (w/ the higher PMI) to avoid over filling storage.

    It is a matter of when, not if. If most of the producers are 100% hedged for '09 (hence likely why their stock prices are not in the toilet w/ NG price) and they have to produce to keep their valuable leases and we have a 100 year supply, then why stop production at any price when you're getting top (hedged) $ any how??? Someone needs to explain to me why will they given these (and many other simar) factors.

    Besides, did you notice that rig counts bottomed in early June and actually started to uptick in July-Aug. Also, day rates never came down enough. Not a good sign if you believe in major production cuts.

    Also, if you look at the last recessions NG droped to around $2.5-2.7 in real terms (adjusting for inflation); however, that was when US NG production was believed to have peaked, which is why we later created infrastructure for LNG imports- and those lows were before we became the Saudi-Arabia of NG with massive supplies. So, it would stand to reason that we'll see below $2 easy; esp. since we got so quickly to $2.5 w/o resistance.

    Moreover, I'm very concerned about the long term pricing of NG. I'm trying to see it as bullish as you do, but many long-term factors seem like it might keep it very low- not the least of which is LNG imports from Russia and Arabs whenever NG is above 3 and strongly when gets back over $4.

    Have a look at the LNG import spike between end '06 and early '07 and it tracks *exactly* with a step down of NG price from 7 to 5. This is insane that LNG could crush prices during a robust US economy. I'm very scared now that with the paltry 2% trend growth expected for the US (and EU?) going forward that they'll dump excess Euro LNG onto the US and repeat that '06/'07 event. This would almost certainly keep NG prices under $4 in the expected weak situation for '10. This is a huge uncertainty in playing '09 weakness esp. if buying into NG driller/services securities to play the "perfect storm" against NG. That is, the LNG would dump just enough supply to easily keep the storage full, thus keeping NG exploration and cap ex down to a minimum, and b/c most NG producers are only partially hedged for 2010 (maybe 30% or less?) then they would get killed in 2010 making there hedged supported stock prices 2009 quite high. This uncertainty really sucks! Can you discount this scenario?

    the EU is expected to recover more slowly than the US so why won't the LNG plays dump what ever they can on the US. As I analyze the charts, the LNG chart tells me a very bad story. That is, the June '09 LNG was sold at only ~ $4.3 while volumes where a little above that just before the '06 event (see above) when NG price in '06 was ~7, and then dumped 2X the volume for 6 months and were more than happy to collect only $5 in that time. Again, this was when the EU and US were heading into a peak earning cycle. This tells me that the LNG players will keep US NG prices in the toilet (<$4) until the US (and EU?) are in a full recovery. Very, very bad for NG sector stocks for 2010. Please debunk this gloom and doom scenario! It seems all too possible if the magal V-shape recovery does not materialize in early 2010. Hence, why with a weak EU they'll dump there LNG at a (double? june '09) high rate and keep the US storage near max, thus NG prices in the toilet.

    I'd really hate to additionally bet on a V-shape recovery on top of the structural NG risks I've discussed. There are much more (risk adjusted) profitable bets on a V-shape recovery in the market.

    Betting on a V-shape recover is over the top for a NG bet at this point. Also, how can you be so sure that that '06/'07 event (see above) won't repeat in 2010?

    In summary, NG prices seem destined to go well under $2 well into November, and while it may rebound next year LNG will keep it near $4 and kill/hurt most US NG producers until the economy fully recovers (1-2 years) and get NG price in the $5-6 range.

    So, you can try buying a goldman sacks blessed short squeeze, or catching a falling knife within a couple weeks, or put your money in soaring NG stocks which will collapse next year when there hedges are gone and NG is kept too low b/c of LNG (also means rig counts will stay 30% below last years numbers for years). Seems like NG is a bad bet until at least Nov.

    Cheers,

    Ari

  • Report this Comment On September 16, 2009, at 10:57 PM, jcrash wrote:

    Nat gas is one of the few commodities that can go negative on price.

    If you don't believe me, you are investing in something you don't know much about.

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