Natural gas is cheap, but where does it go from here?

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In the energy markets, traders call it an anomaly or a price discrepancy, sometimes with a rational basis, sometimes not.

Case in point: the oil/natural gas price ratio. A barrel of oil contains about 5.8 million British thermal units (BTUs) of energy. Therefore, oil should be priced at approximately 5.8 times the price of natural gas.

The 25-year average for ratio of oil-to-natural-gas is 8.6 times natural gas. Today, however, with oil trading at about $67 per barrel and natural gas at about $4 per million BTUs, the average is about 16.8 times natural gas' price.
Natural gas and oil: Overlapping markets

That large price gap, or divergence, constitutes a discrepancy, and it can't last forever, says economist Richard Felson. That's because while the oil and natural gas markets are not identical, they do have overlapping clients, who will switch energy sources, if it's in their long-term cost interest to do so.

Oil, which serves primarily transportation (gasoline, diesel), also faces competition from natural gas conversions for home and business heating, and for power generation and industrial applications.

Meanwhile, natural gas is considered a less elastic energy source and dependent on regional markets, as well as on a network of pipelines that can move natural gas across a continent. True, the U.S. can import up to 20 percent of its natural gas from abroad, but it costs more than regionally-supplied natural gas. Oil, conversely, can be shipped from any wellhead point to virtually any global destination, via oil tanker or pipeline.

"Short-term, major price discrepancies can occur. But over six, nine months, a year, the price reverts to the historical norm of 8.6 times," Felson said.

Given, the supply characteristics, what's most likely to occur: a drop in oil prices, a rise in natural gas prices, both, or the reverse?

The December 2009 futures contract for natural gas suggests it will be a rise in natural gas' price. The December 2009 contract for natural gas traded Monday down 18 cents to $5.64 per million BTUs, for an oil/natural gas ratio of 12.40 times the December 2009 oil contract, which traded at $69.90 per barrel, down $2.99.

Futures data: a price forecast, that can change

Still, Felson said the December 2009 futures data, by themselves, should not be used to calculate which direction prices are likely to move from today, June 22, forward. The reason? "There are too many unknown supply and demand variables for each energy form that can affect prices," Felson said. Two examples include: 1) the fact that in U.S. natural gas output in 2009 has continued to rise despite its low price, and 2) the current $67 oil price assumes rising demand for oil, globally, in the second half of 2009, and in 2010, something that may not occur if the U.S. and global recoveries don't start as expected in Q3/Q4.

If each of the above occurs, natural gas' price will fall, but so will oil's price – "laying waste to the December 2009 futures projection on June 22."

But that doesn't mean the reversion to the historical 8.6 oil-to-natural-gas ratio can't be achieved if both the price of natural gas and oil fall. Oil could fall a great deal, by $30 per barrel or so, bringing the historical ratio back in to alignment, he added.

Natural Gas / Oil Analysis: Large per-energy-unit discrepancies between natural gas and oil can persist for many months, and futures contract prices cannot be used to predict likely price movements. Intuitively, given historical prices, one would argue that natural gas at roughly $4 per million BTUs is cheap, and that natural gas producers would cut back supply as a result. But the latter has not occurred, at least so far in 2009, and there's no barrier that says natural gas prices cannot drop to $3 or even $2 per million BTUs.

Bottom Line: For U.S. homeowners, I would still favor a natural gas heating system, or, where a budget allows, a system that can switch between the two. The bias is toward natural gas for domestic energy source reasons, but that's not to argue that heating by natural gas will always remain cheaper than heating by oil. The natural gas bias stems from the many geopolitical factors that can affect oil's supply, and the relative reliability of domestic natural gas.
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