Natural Gas and Oil Divergence
The TK blog wonders why crude oil prices (proxy ticker: USO) and natural gas prices (proxy ticker: UNG) have undergone such a divergence of late. Professor Donald Marron shows that the historical trading range — where crude typically trades at 5x to 10x the price of natural gas — has been blown out of the water, and crude now trades close to 24x the price of natural gas. Considering that one barrel of oil (the price unit quoted) has 6x as much energy as one thousand cubic feet of natural gas (the price unit quoted), the trading range makes sense. But that’s done you no good if you’ve entered a paired trade of long nat gas and short crude, as the squeeze has cost you money so far.
Consider three factors that affect both crude and nat gas: supply, demand, and technical pricing. There haven’t been any significant new discoveries of oil lately — but the Haynesville Shale discovery could yield a decade’s worth of natural gas consumption at below-market production costs. That’s one strike against natural gas bulls. As for demand, about 45% of oil is used as fuel for motor vehicles – a relatively inelastic demand source. Other major demand components are propane and asphalt, so if you’ve been driving, grilling, or hearing about infrastructure spending as a source of stimulus, you should be aware that all translates to higher demand for oil. In other words, oil demand typically peaks during the summer, whereas natural gas…
Normally peaks in the winter, since it heats and cools more than half of homes in America. But it has been a cool summer, and industrial activity (35% of natural gas consumption is residential, 25% is industrial, and 21% is for electricity generation) is tepid at best, and overall electricity demand is down. This translates to less-than-usual demand for natural gas. That’s two strikes on natural gas bulls.
Finally, technical pricing factors. Crude oil is denominated in dollars worldwide, whereas natural gas is a more localized market. This means that as the dollar falls relative to other currencies, the price of oil on the world market increases. The dollar (proxy ticker: UUP) has fallend 12% in the last six months, and that has contributed directly to the rise in oil with no benefit to natural gas. Taken together, these three powerful factors show why natural gas bulls have struck out on their bet for higher prices, and what factors they need to turn in their favor if this trade is to reverse.