Oil and Natural Gas Prices: How Are They Related?

March 2011

• Prices for crude oil and natural gas have diverged since 2009 to the point where the ratio between crude oil and natural gas near-month prices is now approximately 25 to 1.
• The recent relationship between oil and natural gas prices reflects important differences in these commodities. Their market characteristics differ, with oil traded globally and natural gas still considered a continental commodity. Gas has been undergoing the "shale revolution", but there is nothing comparable for oil.
• However, developments in the crude oil and natural gas markets can still affect each other. Recent relative returns from the two commodities may have motivated oil and gas companies to shift resources to oil production and exploration, and away from gas.
• There may be no "normal" relationship between oil and gas prices, but when the relationship is pushed to extremes, it may offer some insight into future long-term developments for the industry.

During the run-up in commodity markets in 2008, Aegent examined the relationship between prices of crude oil and natural gas. Today, with crude oil over US$100 per barrel again but natural gas near US$4 per million British thermal units (MMBtu), we thought it was worth revisiting the topic.

It is often stated that on an energy-equivalency basis, a barrel of crude oil has roughly 6 times the energy content of a million British thermal units. Given the current price of oil, and absent any other influences, this would mean that the current near-month natural gas contract on NYMEX should be trading near $17/MMBtu ($100/6). Conversely, with gas around $4/MMBtu, the current near-month crude oil NYMEX contract should be trading close to $24/barrel ($4 x 6). However, current prices do not bear out this relationship. Indeed prices for these commodities have diverged since 2009 to the point where the ratio between crude oil and natural gas near-month prices is now approximately 25 to 1. The correlation between the prices of these commodities has fallen from an average of 47% between 2001 and 2008 to -22% for 2009 to 2011-to-date.

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

Crude oil and natural gas are not substitutes for each other for most end-users. Most consumers do not have access to machinery or vehicles that have instantaneous fuel-switching capabilities. As recently as 25 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 recent uprisings in the Arab world and consequent fluctuations in crude oil prices 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 measure of liquefied natural gas is shipped intercontinentally.

Natural gas has been undergoing the "shale revolution" in North America with supply estimates being revised upwards. Shale gas is increasingly expected to offset the declining output from conventional deposits of natural gas. Nothing comparable has happened for crude oil, and there seems to be a greater likelihood that crude oil prices will only increase further as supply diminishes, barring the exploitation of unknown sources.

This is not to say that developments in the crude oil and natural gas markets cannot affect each other at all. Since the peak of the recession in the first half of 2009, crude oil prices have grown steadily as demand has grown with gradually improving economic conditions. In addition, drilling activity for crude oil has risen with rig operators seeking to meet demand in an increasingly profitable environment. In contrast, drilling activity for natural gas has stagnated for much of the last 12 months as the combination of low natural gas prices and high prices for crude oil have magnified the bias towards drilling for crude oil over natural gas. The relative returns from the two commodities may tend to motivate oil and gas companies to shift resources to oil production and exploration, and away from gas. In this sense, oil and gas are still substitutes, as exploration dollars that used to flow to one commodity will in time increasingly flow to the other.

What this means is that the relatively lower level of natural gas drilling caused by low prices for natural gas relative to crude oil may have led 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.

There may be no "normal" relationship between oil and gas prices, but when the relationship is pushed to extremes in one direction or the other, it may offer some insight into future long-term developments for the industry, but apparently less insight into predicting movements of prices for the short-term.

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