Oil Up, Gas Down, When Will They Come Back in Line?

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For those used to thinking of the oil and gas industry as being one seamless whole there is no better illustration of how flawed that perception can be than looking at the current market. Oil and gas often arise from the same reserves, and companies that drill for oil are well qualified to drill for gas, but the markets into which the two hydrocarbons are sold are often driven by very different dynamics. The most significant of which in recent years has been that oil is a global play (with slight premiums and discounts driven by local supply and demand) but gas is almost wholly a local play and may bear no relation to what is happening in the oil market.

Take the US. At present, the relationship between crude oil and natural gas prices has widened to the most divergent position since the early 1990’s. West Texas Intermediate WTI rose this week to $74.81 a barrel, its highest level this year according to the FT, but Nymex September Natural Gas dropped to a fresh seven year low of $2.727 per million BTU’s. That puts the price ratio of natural gas to crude at over 26 to 1, the widest since 1990. The average ratio over the past year has been 12.8 to 1. The reason is not hard to see. Crude prices have been driven higher by a combination of OPEC capacity cuts and continued strong demand from Asia, particularly China and India. Speculators look at the figures and see China’s implied oil demand in July increased 3.5% over the same period last year as imports continue to rise. This has pushed up the price of crude around the world even though consumption is down and stocks are up in crude hungry markets like North America. The US is also awash with natural gas reflecting the current level of economic activity but unlike oil, gas is not as readily a transportable fuel source and an excess in one location results in price depression. Consequently prices are low in North America and in Europe where LNG terminals receiving cargoes from the Middle East are full and gas demand from Russia is 40% down this year from last. Gas on the spot market is half the level of long term contact prices reflecting the supply demand imbalance.

Some industry observers do not see the ratio of oil to gas prices likely to return to a historical norm anytime soon, pointing to strong demand in China and the supply cuts as reasons for a continued high oil price. But others feel that although a significant rise in natural gas prices is unlikely anytime soon (the mature economies are coming out of recession but the return to growth is going to be slow and erratic) oil could drop back if the current wave of enthusiasm that is supporting the stock and commodity markets were to waiver. If that happens, the price of certain energy intensive metals like aluminum and zinc could be particularly vulnerable as part of the justification for their current price is the high price of oil.

–Stuart Burns

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