Donald Marron
submits:
My recent post about
oil and natural gas prices
elicited some very constructive responses from readers (thanks in
particular to PJ, MF, and FW, in addition to public commenters on
that post). As a result, I've rethought my discussion of the
relationship between oil and natural gas prices.
I was also inspired to look at the futures markets to see what
they are signaling about the relationship between oil and natural
gas prices. Here's my usual chart of the ratio of oil prices to
natural gas prices, now showing both history (lighter blue) and
futures markets (darker blue):
As noted in my earlier posts, oil and natural prices appear to
have disconnected from their historical relationship. For many
years, oil prices (as measured in $ per barrel) tended to be 6 to
12 times natural gas prices (as measured in $ per MMBtu). That
ratio blew out to more than 20 in late 2009, then receded to more
traditional levels, and then blew out again in recent months. At
Thursday's close, the ratio stood at 21.8, far above its historical
range.
In my previous posts, I argued that this unusual pricing
reflects the sudden (and welcome) increase in natural gas supplies
and that we should expect oil and natural gas prices to eventually
move back toward their historical relationship as markets absorb
the new gas. Of course, I was careful not to say when this would
happen.
As shown in the graph, the futures markets are indeed signaling
some normalization in the price ratio in coming years, but not a
rapid one. Moreover, even after eight years, the ratio would return
only to the upper end (12) of its historical range. (Caveat:
Futures markets are quite thin that far out, so we shouldn't place
too much weight on those distant prices.)
Let me offer a revised interpretation of the pricing
relationship that's consistent both with the futures data and the
comments I received. This interpretation (consider it a theory,
really) distinguishes four time periods:
-
Good Old Days:
For many years, the electric utility industry had generating
plants that ran on oil, natural gas, or both. The ability to fuel
switch (either by changing the dispatch order of oil and gas
plants or changing fuels at plants that could use either) limited
how much oil and natural gas prices could deviate. If oil prices
fell too low, utilities would move from natural gas to oil, and
vice-versa. Similar fuel arbitrage occurred, to varying degrees,
among other uses as well (e.g., home heating and some industrial
uses).
-
More Recent Days:
In recent decades, electric utilities have embraced natural gas
and moved away from oil. As a result, there is much less
opportunity for arbitrage between the fuels. The same has
happened among other fuel consumers as well. Oil and natural gas
prices nonetheless remained within their usual historical
relationship. For example, oil and natural gas prices rose and
fell in tandem during 2008. This suggests that the markets
encountered similar shocks during those years (e.g., strong
demand or, some would argue, speculation), not that they were
linked via arbitrage.
-
Today:
With the decline of traditional fuel arbitrage possibilities, oil
and natural gas prices can now move separately if they experience
distinct shocks. That appears to have happened with the increase
in natural gas supply, for example.
-
Future:
Looking further ahead, however, one would expect some new
arbitrage relationships to develop. If we have persistently cheap
natural gas and persistently expensive oil, that creates an
incentive for ingenious folks to find ways to use natural gas to
serve what have traditionally been oil demands. That should
eventually limit the degree to which the prices can deviate
(although not necessarily in the 6 to 12 ratio range). Two
leading candidates for this linkage are using natural gas as a
transportation fuel (directly as a fuel and perhaps indirectly as
electricity) and increased international trade in liquified
natural gas.
Note: The chart uses the spot price for West Texas Intermediate
at Cushing and the spot price for natural gas at Henry Hub on a
monthly basis through March 2010. For April 2010, I use the closing
prices on April 8. The monthly futures are from the CME Group (
CME
).
See also
Ensco Plc. Q1 2010 Earnings Call Transcript
on seekingalpha.com