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Rethinking Oil and Natural Gas Prices

Posted
4/11/2010 4:56:00 AM
By: SeekingAlpha
Referenced Stocks:CME;DBO;OIL;UNG;UNL
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:

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