According to the EIA, the ratio of crude oil price per barrel to natural gas in dollars per MMBtu is ?6:1 if prices were based on thermal content alone. However, before we get into a technical discussion we want to acknowledge the hotly contested debate as to whether there is a link at all between oil and gas based on the fundamentals.
- Proponents of the link note that oil and gas are substitutes. Therefore, inherent price competition mitigates excessive decoupling between the two fuels.
- Naysayers argue against this view given the diminished role of black fuels at dual-fired plants. The extreme volatility we have been seeing between these two fuels buttresses their argument.
As of last Friday the ratio between spot NYMEX WTI ($/bbl) to the corresponding Henry Hub contract ($/MMBtu) was 17.3:1. In today’s Chart of the Day in The Schork Report we posted the NYMEX ratio (adjusted per contract points). Either way, upon first glance it would appear that natural gas is a buy relative to crude oil.
However, first looks are deceiving. The relationship between crude and natural gas has been acting very strangely in the last few months. Quantitatively, we expected a price correction to reduce crude and increase natural gas prices, but that hasn’t happened… yet. In other words, we are used to seeing a positive correlation between contracts, but crude’s run has not pulled up natural gas prices in tandem to the extent expected (most studies cited by the EIA find that natural gas prices depend upon crude oil prices, but not the reverse).
Back in March, when discussing the relationship between crude oil and natural gas, we said “To be fair, 2009 will probably not see the extreme correlation between natural gas and crude oil apparent in 2008” (TSR-20090303).
If we could travel back to March in a Delorean à la Michael J Fox, we would append several (hundred) exclamation marks to that statement. The correlation co-efficient in May of 2008 was 0.833. In 2009 it’s a negative (0.101). Crude is completely failing to exert upward pressure on gas prices like it did last year.
As mentioned in yesterday’s issue of The Schork Report , Henry Hub gas fell from a $4.690 high inside the first half of last month, to a $3.835 on close of Friday before yesterday’s 40 cent jump. Crude on the other hand has increased from $51.12 at the start of the May to $68.58 as of last night.
Over the same period last year, crude jumped from $112.52 to $127.35 over May, but then Natural Gas prices moved from $10.56 to $11.7. By that relationship, if gas prices depended on nothing except crude, we should have seen an average natural gas price in May of $5.10. The gap between predicted and actual should also reinforce the low correlation, mentioned earlier, as natural gas prices failed to move in tandem with crude especially by 14th May onwards. Any moving average indicator will tell you that the Natural Gas price is currently too low, especially if we look at the underlying stocks.
The correlation between natural gas builds/draws and prices is negative (0.65), while the corresponding figure for crude is a weaker negative (0.50). Given that natural gas production fell 0.5% in May, the poor margins and the extant purge in rig counts, we can expect a further curtailment in output. That should lead to a bullish market for natural gas. But technically, it should have led to this weeks, if not months, ago and prices should not have fallen from the $4.45 mid-May high. What’s worse, June isn’t a shoe-in for price recovery, as it follows a bearish historical trend, with natural gas prices falling 4.74% on average over the 03-07 timestep.
We’d love to root for the bulls, because it’s with them that the statistical fundamentals side. Crude is trading on fumes and late-to-the-game investors jumping on the crude oil lifeboat while the market continues to under price natural gas.
As long as the equities boom lasts, look out for higher than expected summer driving season demand which could go some way to helping natural gas recover and catch up to crude.
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Stephen Schork is the Editor of, "The Schork Report" and has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.