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Natural gas is looking very cheap right now relative to oil prices. This
is undoubtedly one of the most glaring discrepancies at work in the
energy markets today. While oil prices have soared to new highs, natural
gas sits at less than half its 2005 top. Check out the chart below.
StockCharts.com
This chart depicts a
simple ratio--the price of natural gas divided by the price of oil. When
this ratio is falling, gas prices are falling faster than oil prices or
rising more slowly; the opposite is true when the ratio is rising.
To better illustrate the long-term trend, I've offered a chart covering
10 years of data. The last time gas prices were this low relative to oil
was in late 2001. In addition, we can see two other spikes to these
levels on the ratio--one in late 1996 and another in late 1999 to early
2000.
Whenever the ratio gets this extended to the downside, it tends to snap
back to a more average level, a process known to statisticians as mean
reversion. In many cases, the ratio ultimately shoots way above the
long-term average, with natural gas prices becoming stretched relative
to oil. This occurred in early 2001 during the California power crisis
and again last year in the wake of Hurricane Katrina and the Gulf Coast
gas supply disruptions.
I suspect that once again we will ultimately see the gas/oil ratio climb
back to a more average level. This mean reversion adjustment can be
accomplished in two ways: Oil prices could fall from current levels,
and/or natural gas prices could rise. It's interesting to note that on
prior downside spikes in this ratio, the latter scenario
developed--natural gas prices rallied faster than oil.
Specifically, in late 1999 through the end of 2000, natural gas prices
shot up from around $2 per million British thermal units (MMBtu) to
nearly $10 per MMBtu, a five-fold increase. Meanwhile, oil prices were
essentially flat in the $25 to $36 area throughout this entire period.
And in late 1996 gas spiked from $2 to $4.50, while oil moved up from
$20 to $25 blue barrel (bbl). Gas more than doubled in this period,
while oil rose just 25 percent. Finally, in late 2001 through early
2003, gas prices also rose faster than oil causing the gas/oil ratio to
mean revert.
Catalysts For The Shift
Fundamentally, sentiment on gas is extraordinarily bearish right now
because storage levels of gas are so high. Basically, a warm winter
meant that demand for electricity was lower than average; this allowed
producers to actually build considerable inventories of gas in storage.
As my chart below illustrates, inventories of gas are seasonally much
higher right now than at any time in the past five years.
Bloomberg
Summer demand for gas is
starting to build. As the weather heats up, look for power plants to
start burning gas; this will gradually work to reduce the gas glut. Of
course, demand will take several weeks to really begin to work through
inventories--the adjustment process caused by demand pull will be slow.
But there are other factors that could catalyze a faster reduction in
gas inventories. Chief among those would be another major supply
disruption in the Gulf of Mexico this year caused by a major hurricane
in the region. Forecasters are calling for another busy hurricane
season, so this is certainly not an improbable event. Even a few weeks
of Gulf supply disruption could result in a major decline in inventories
of gas, just as it did last year. Supply disruptions coupled with hot
summer weather would have an even greater impact on pricing.
Moreover, I see a price floor for gas near $5 per MMBtu to $5.50 per
MMBtu. At around that level, utilities would start cutting back on
output from coal plants and rely more heavily on natural gas-fired
generation. This is particularly true in light of ever-more-stringent
environmental regulations. Such a switch would clearly raise demand for
natural gas and put upward pressure on pricing.
And I also suspect that smaller natural gas producers will begin to cut
back on production or at least delay projects if gas prices fall much
beyond $5 to $5.50 per MMBtu. This, too, could reduce the supply of
natural gas in the intermediate term.
Finally, last winter was an aberrantly warm one. It's highly unlikely
that the 2006-07 winter will be as warm. Thus, inventory drawdowns late
in 2006 could well form another catalyst for gas demand and inventory
drawdowns.
It's absolutely impossible to predict which, if any, of these catalysts
will come to pass. However, with sentiment so bearish on gas right now
and inventories so high, it will not take much bullish news to get gas
prices moving once again. And it's hardly a stretch to say that one of
these catalysts is likely to emerge during the next six to nine months.
Bottom Line
During the past few months, I've been highlighting the big natural
gas/oil discrepancy in The Energy Strategist. In early
April, I even compared natural gas and oil prices on a British
thermal unit (Btu) basis. Basically, Btus are a measure of energy--we
can directly compare the price of energy produced using coal, oil or
gas.
The US Energy Information Administration estimates that an average
barrel of crude contains 5.8 million Btus of energy; the current cost
for that barrel is around $70. But with gas at $6, 5.8 million Btus cost
just $34.8. In other words, on an energy equivalent basis, gas is half
as cheap as oil. This is unlikely to persist longer term.
During the next six to nine months, I suspect that gas-levered producers
will outperform producers levered to oil prices--in the next issue of The
Energy Strategist, I'll be looking at ways to play that trend.
Moreover, my bullish position on natural gas has ramifications for the
shallow-water drilling market in the Gulf of Mexico; I see a major
shortage of shallow-water jackup rigs developing in the Gulf later this
summer.
© 2006 Elliott H. Gue
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