Do prices for crude oil drive natural gas prices?

March 2015

• While crude oil and natural gas are “related’ commodities, they are distant relations when it comes to pricing.
• Currently, natural gas is trading under $3/MMBtu making the value of crude oil to natural gas about 3:1 on an energy-equivalent basis.
• The two commodities trade in different markets, influenced by different supply and demand factors.

There is a widely held perception that the price for crude oil drives the price for natural gas, and that the recent slide in oil prices has helped to push natural gas prices down.

Like many widely-held perceptions of the energy market, this perception is wrong. On inspection, it can be seen that crude oil and natural gas prices move largely independently of one another, for a variety of reasons. Most importantly, while they are both fossil fuels, they trade in very different markets, with each commodity finding the price determined by supply and demand in its market.

A barrel of crude oil contains roughly 6 million British thermal units (MMBtu). At $46 per barrel, crude oil is worth about $7.65 per MMBtu. Currently, natural gas is trading under $3/MMBtu making the value of crude oil to natural gas about 3:1 on an energy-equivalent basis. In December 2000 , natural gas was actually twice the value of crude oil on an energy basis, when a cold winter pushed gas prices up while oil was languishing during a recessionary period in the economy. In April 2012, crude oil was almost 9 times the value of gas on an energy basis.

Over the past two decades, price movements of these commodities are moderately positively correlated with a coefficient of 0.45. (A correlation of 0.45 is not very strong, and in any event, correlation does not imply causation.)

Although oil and natural gas are both fossil fuels, and the prices of most commodities tend to move together, the fluctuating relationship between oil and natural gas prices reflects important differences in these commodities.

Crude oil and natural gas are not substitutes for each other. Liquid fuels derived from crude oil are produced from the refining process, and are subject to influence on supply and demand, such as the availability of refining capacity. While the price of furnace oil will clearly be influenced by crude oil prices, there are other factors at play as well. Most consumers no longer maintain equipment that has instantaneous fuel-switching capabilities. As recently as 30 years ago, it was much more common for industrial users of boiler fuel to have facilities that could burn both natural gas and either bunker oil or furnace oil. Environmental considerations and the consistently lower price of natural gas on an energy-equivalent basis have resulted in most of that dual-fuel capacity being replaced with gas-only capacity over time.

In addition, the market characteristics of these commodities differ, reducing further the opportunities for substitution. Crude oil has for some time been traded globally with its intercontinental pipelines and well-established tanker routes. The price fluctuations stemming from recent turmoil in the Arab world or OPEC’s policy decisions underline the importance of Middle Eastern crude oil as an input for global economic growth and just day-to-day living. On the other hand, natural gas is still considered largely a continental commodity, despite the fact that some liquefied natural gas is shipped intercontinentally.

Even within the continent, natural gas prices are not uniform, and differences can arise when local demand exceeds existing pipeline capacity regardless of the quantity of gas that producers extract. Natural gas prices are also more sensitive to weather than crude oil prices given the greater use of natural gas for space-heating and electricity generation than heating oil or fuel oil. For example, the unusually mild winter of 2011-12 is behind the steep increase in the ratio of crude oil and natural gas prices as the latter fell even further from crude oil prices because of lower space-heating demand.

Natural gas has been undergoing the “shale revolution” in North America with supply estimates being revised upwards. Shale gas is the reason why US domestic natural gas supply has increased by 20% in the last four years, despite declining conventional reserves.

The shale revolution has also hit US domestic crude oil production. US daily crude oil supply as of 2013 exceeded even that of Saudi Arabia and Russia. When combined with OPEC’s recent reluctance to reduce daily production in the face of weakening demand, prices of crude oil have fallen back toward levels last seen in the Great Recession.

This is not to say that developments in the crude oil and natural gas markets do not affect each other at all. Many energy companies are producers of both oil and gas. While some producers, as a matter of corporate strategy, choose to focus on either gas or oil, many simply shift their focus from one to the other commodity in response to economic conditions. When oil prices are high and gas prices are low, exploration and development budgets will tend to shift to the pursuit of crude oil rather than natural gas.

The relatively lower level of natural gas drilling caused by low prices for natural gas relative to crude oil may lead to a situation where the rate of natural gas supply growth slows down, leading to a tighter balance in natural gas supply and demand, and higher gas prices.

The shale revolution has affected this dynamic, with drilling methods for shale gas and oil proving so prolific that production continues to grow despite a decline in drilling activity.

While crude oil and natural gas are “related” commodities, when it comes to pricing, they are distant relations. The two commodities trade in different markets with different supply and demand factors at play, resulting in very different price behaviour.

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