One of the biggest anomalies in the North American natural gas market over the past year has been how disconnected natural gas prices have become from those of its close substitutes – oil and coal. The historical relationship between the price of natural gas and oil, which has averaged 10:1 over the past two decades, has now moved to approximately 20:1.
Changes in environmental regulations that favor use of natural gas over coal as feedstock for electricity generation facilities, coupled with a spike in coal prices, have caused natural gas to trade below the “coal floor” for more than a year. The coal floor is the price at which electrical utilities shut down coal plants and increase use of natural gas fired power plants.
In this article I will examine the connection between natural gas prices and those of oil and coal from a variety of angles. Also, I will show that while a number of factors may move prices beyond historical norms in the short-run, there still exist powerful forces that will revert these relationships back to the mean in the long-term. A reversion to historical pricing norms is strongly bullish for natural gas prices. As always, I will provide several ways to profit from this trend.
While there has been much written about the correlation between gas and oil prices over the years, no authors have presented the relationship more succinctly than Stephen Brown and Mine Yucel, two researchers at the Federal Reserve Bank of Dallas. In their 2007 white paper/presentation entitled “What Drive Natural Gas Prices?”,* the authors present a very thorough review of three of the most commonly used rules of thumb when comparing oil and gas prices. They are as follows:
10-to-1 rule: Under the 10-to-1 rule, the natural gas price is one-tenth the price of oil. For example, a $50 price for a barrel of WTI crude oil would indicate that natural gas should trade at $5.00 per million BTU at Henry Hub. The 10-to-1 gas/oil relationship has been the most accurate rule of thumb over the past 10 years as evidenced by the below table:
*(Here is a link to presentation: https://search.newyorkfed.org/dal_public/search?Begin+Search.y=0&number=10&Begin+Search.x=0&start=10&Begin+Search=Begin+Search&text=stephen+brown+natural+gas+prices)
6-to-1 rule: Another common rule of thumb for the relationship between gas and oil prices reflects the energy content of the two commodities. Since one barrel of oil contains the energy equivalent of the 5.825 million BTU of natural gas, the 6-to-1 rule was developed. Applying this rule, should oil prices trade at per barrel of WTI, natural gas should trade at .58. Brown and Yucel observed that although the 6-to-1 rule is less accurate than the 10-to-1 rule over long observation periods, in times of rising gas prices, the 6-to-1 rule is a more accurate predictor of natural gas prices. In periods of declining natural gas prices however, the 10-to-1 rule is a more accurate predictor.
Figure 1 below shows the 10-to-1 Rule, the 6-to-1 Rule and the actual spot price of natural gas from 1994 through 2006.
Source: Brown and Yucel
Burner Tip Parity: The burner tip party rule is more complex than either of the two previously discussed rules in that it takes into account the relationship between natural gas and the petroleum production with which it competes at the burner tip. According to Brown and Yucel, the burner tip parity rule “shows natural gas pricing yielding parity with residual fuel at the burner tip, and the price at Henry Hub adjusting to whatever is necessary to achieve burner-tip parity.” Since a barrel of residual fuel has an energy content of 6.287 BTU, and historically residual fuel is priced at 95% of WTI, the burner tip parity rule would suggest that a price per barrel of WTI would result in a .06 per million BTU price for natural gas.
In addition to the above three rules for describing the correlation between oil and natural gas prices, Brown and Yucel also discuss other factors that impact the oil-gas price relationship. One little discussed influence on U.S. natural gas prices is the worldwide price of petrochemical products. The authors point out that since the U.S. petrochemical industry relies heavily on natural gas as a feedstock, while a significant portion of the international petrochemical industry uses oil as a feedstock in its manufacturing processes, a pricing arbitrage exists during periods of low gas prices in the U.S. Therefore, should U.S. natural gas prices remain below their historical norms for an extended period, petrochemical imports into the U.S. will decline and domestic manufacturing will expand and increase demand for natural gas.
Another factor influencing the oil to gas price relationship in the U.S. is the price of liquefied natural gas (LNG). With an increasing percentage of the world LNG pricing linked to world oil prices (exporters are now demanding oil linked pricing), LNG imports into the U.S. will remain at very depressed levels unless natural gas prices rise substantially. Imports into the U.S. are currently approximately 1 billion cubic feet per day (bcf/d) despite approximately 12 bcf/d of import capacity. However, if we look at gas prices in the U.K., a country which has seen domestic gas production fall and now relies more heavily on LNG imports, we see a much closer link between oil and gas prices. On 1/26/2011 spot natural gas in the U.K. was priced at .64 per million BTUs and Brent crude priced at approximately . Therefore, the current gas-to-oil ratio in the U.K. is approximately 11:1. Since the U.S. imports virtually no natural gas via LNG on a long-term fixed contract basis and the UK will likely continue to offer the best terms for spot cargoes in the Atlantic Basin due to further declines in domestic production, I do not expect any increase in LNG imports into the U.S. until spot prices are well over .00US per million BTUs.
Brown and Yucel’s final reason oil prices drive natural gas prices is the re-allocation of drilling funds by natural gas producers away from natural gas projects and towards oil projects. In today’s world of approximately US per barrel WTI oil prices and .35US per thousand cubic feet (mcf) natural gas prices, operators are aggressively re-directing funds towards oil projects. It comes as no surprise that most independent operators are now concentrating on their oil projects given that oil and gas wells cost about the same to drill and oil wells generate nearly three times the revenue on a barrel of energy equivalent basis. The focus on oil projects and liquid rich natural gas projects has led to a drop off in the natural gas directed rig count in recent months and a concurrent increase in the oil directed rig count. We see the preference for oil drilling over natural gas drilling displayed very clearly in the weekly Baker Hughes rig counts. The below graph shows the large upswing in both gas and oil directed drilling over the past two years as well as the recent fall off in natural gas directed drilling:
(Source: Baker Hughes)
There are two important reasons oil directed drilling will continue to rise and natural gas directed drilling should continue to fall. First, a significant portion of today’s natural gas directed drilling, as much as 25%, is being conducted to hold soon to be expiring leases. Many leases in the Haynesville and Fayetteville shale were signed with terms stipulating that to maintain the lease in good standing, a well must be drilled within three years of lease signing. With much of the prospective acreage already held by production (HBP) in these two shale plays, operators have begun reducing operations in these areas until economics improve. According to Baker Hughes, Louisiana and Arkansas, home to the Haynesville and Fayetteville shale plays, have fewer rigs operating than at the same time last year due to declines in shale directed drilling. While rig efficiency gains, such as pad drilling will reduce drilling time per well and will certainly offset fewer rigs active in natural gas shale plays, drilling more shale wells closer together will not grow shale gas production enough to offset an expected 10% decline in conventional US natural gas production this year.
A final reason oil prices are now driving natural gas prices is that inflation in oilfield services, especially pressure pumping, have driven up drilling costs to the point where most natural gas wells are uneconomic at today’s prices. Readers of this publication should not be surprised by the surge in oilfield service inflation since I discussed this topic in depth in an article entitled the “Pressure Pumping Chokepoint” (July 1, 2010 issue). (Pressure pumping is the pumping of water and sand into a wellbore that has been perforated to prop open fractures to allow hydrocarbons to flow to the wellbore.) With new unconventional oil plays coming online in the past year and operators drilling more and longer lateral wells requiring more fracture stimulation jobs than ever before, demand for pressure pumping services has risen dramatically. I expect further increases in pressure pumping prices in 2011, which, in turn will further reduce the U.S. natural gas directed rig count unless gas prices move dramatically higher.
Coal vs. Natural Gas
A number of factors have distorted the traditional relationship between coal and natural gas prices to unsustainable levels. Since most of America’s utilities have the ability to employ natural gas fired power plants in lieu of coal fired power plants when natural gas is priced advantageously, utilities have been ramping up natural gas consumption and reducing their usage of coal. With the price of Central Appalachian (CAPP) coal currently trading at per ton, up from per ton for much of last year, a recent study by Credit Suisse (CS) indicates that natural gas prices would need to rise to approximately .30 per mcf before coal and natural gas trade at parity for electricity generation. As you can see from the below graphic, natural gas is well below parity for not just 2011 but also for the next several years:
With such a large gap between coal and gas pricing parity, we have already seen a substantial amount of switching by utilities from coal to natural gas. According to CS, in October 2010, natural gas usage for electricity generation was up 6% year over year while consumption of coal for electricity generation was down 4% year over year. More importantly, CS sees even more switching to natural gas in the months and years ahead as tighter environmental rules make coal usage increasingly expensive. For example, CS sees natural gas demand increasing 5 bcf/d should new EPA rules regarding release of nitrogen oxides, sulfur oxides and mercury by coal fired power force the closure of all small coal fired power plants without environmental controls (60 GW of 340 GW total) by 2017 and a potential 10.2 bcf/d should all small and large dirty coal plants (100 GW total) be closed by 2017.
Despite the all of the evidence that today’s natural gas prices are unsustainable in relation to oil or coal, many of today’s biggest gas traders are still betting big that the recent jump in prices to $4.75 per mcf on the NYMEX was just a fluke. No natural gas futures contract on the NYMEX trades over $5.00 until January 2012. While shorting natural gas has been a very profitable strategy over the past two years, and a very popular one as well, I believe the fundamentals of natural gas will soon get the long awaited rally in natural gas started. When shorts start covering we will see a spectacular rally in natural gas. There are many great ways to participate in the bull market for natural gas such as the several gas-weighted equities in my newsletter Model Portfolio as well as several commodity ETFs.
