Oil and Natural Gas Prices Disconnect Again

Last summer I noted that oil and natural gas prices had diverged to an unprecedented degree. I bravely predicted that this divergence would reverse (unbravely, I didn’t predict when).

As the chart below shows, I was right: the price relationship did move sharply toward normal levels. In the last two months, however, it’s blown out again:

Click to enlarge

The chart shows the ratio of the price of oil (measured in $ per barrel) to the price of natural gas (in $ per MMBtu). Under normal circumstances, that ratio fluctuates between 6 and 12. A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would thus tend to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded higher.

Natural gas closed Thursday at $4.11 per MMBtu. Under normal circumstances, that would imply an oil price of around $25 to $50. But oil actually closed above $85. As a result, the ratio of oil prices to natural gas prices is up at 20.7, well above the usual range and closing in on the peaks of last summer (on the day before I wrote my earlier piece, the ratio reached 24.5).

Where do prices go from here?

Well, history still suggests that the price gap will eventually narrow, through some combination of oil prices falling and natural gas prices rising. But there’s no guarantee that will happen in the short-run. Over the longer-term, however, I feel confident that demand for natural gas will rise to meet the new supply (the prime reason why natural gas prices have been so low recently) and that the oil vs. natural gas price relationship will eventually move back to normal. Natural gas is cleaner than coal and is available in large quantities in the U.S. and Canada. As a result, natural gas is on the short list of potential responses to climate change and oil dependence, two concerns that aren’t going away anytime soon.

Note: The chart uses the spot price for West Texas Intermediate at Cushing and the spot price for natural gas at Henry Hub. Both series are monthly, except for the prices for Thursday, 4/01/10.

P.S. Note that I have again obeyed the first law of forecasting: I have given a prediction (the relationship between oil and natural gas prices will normalize), but I haven’t given a date.