Dave's Energy

Thursday, March 08, 2012

Explaining the Disparity Between Oil and Natural Gas Prices in the U.S.

My good friend Ray Conley at Creekstone Capital pointed out the continuing divergence of the market prices of crude oil and natural gas. Being a brilliant math guy and investment guru, Ray knows that statistical aberrations rarely last long and typically are subject to mean reversion. In the case of oil and gas prices, there should be, in the long term, some energy equivalency that keeps their respective prices from continuing on a divergent path. I agree with Ray, in the long term, but I also discussed with him some of the factors that can (not necessarily will) keep the price of oil and natural gas at an "unnaturally" wide spread.

None of this discussion will sound unfamiliar to most hard-core energy guys, but for the sake of other readers, I will just point out a few well known factors driving the oil and gas business right now. I start out by cautioning against the assumption that the price spread shown in the chart above MUST revert to the mean in any short period of time. No doubt there is an argument for energy equivalence: that each commodity is merely used to produce energy and they are therefore "substitutes" from an economist's point of view. But that economist perception ignores some key differences, which are becoming more prevalent.

First of all, to point out the most obvious factor, crude oil is used to make gasoline and diesel and is primarily tied to the transportation needs of the world. There are other marginal uses to produce power and heat (fuel oil) but these are relatively small markets. Natural gas, on the other hand, is not used for transportation fuel - it is used to generate electric power, for residential use (heating, hot water, etc), and as a feedstock for industrial purposes (plastics, chemicals, etc).

About 10 years ago, there were more industries where the two fuels were, at the margin, substitutes for each other. They were/are substitutes mainly in industrial applications where firms can switch their dual-fuel boilers between the two, and for some power producers that could burn either fuel in a power plant.

Historically, that was a big deal when 1) there was less natural gas supply, and 2) industrial use was a bigger part of gas demand. That isn't the case anymore, highlighted by these charts from Nader Masarweh and the California State University - Sacramento Energy Research blog , shown below. Note that there is more total natural gas now (a great deal more), that supply has grown dramatically faster than demand, and that the power sector has become the more important (larger) user. The power sector is a more "sticky" user that doesn't switch fuels based on price, so price divergence between natural gas and crude oil takes on less meaning in today's world. Take a look and then read on below...

Further, I would argue that any fuel switching based on price may have occurred already, based on the divergence of price over the last 2 years. Once all the switchers had done so, the two prices are free to diverge even more so as they would no longer be tied.

And, in the end, crude oil is a transportation fuel that has its own demand and supply curves. And Nat gas is a power fuel that also has its own supply and demand curves. Each will likely work independently to ultimately get the differential to close the existing gap, but not because it MUST, just because crude oil is high and forces are working on demand and supply and because gas is cheap and forces are working there, too. However, those are long term movements. The power sector will continue to increase their use of gas because it is cheap, clean, and plentiful. Many coal plants will be replaced. It could take years before the demand catches up to our new gas supply capacity. Every gas company I talk to has years of wells in inventory they can drill quickly if and when prices rebound, so although low prices are certainly already working marginally on the supply side, we have gotten so good at creating new gas wells at low cost that supply can expand fairly easily if prices start to rise again. I believe it will take a large push on the demand side to really pull gas up hard. That will take years for the long-term balance....or a severe winter where we strain our short-term capacity and drain existing storage.

Another reason many companies continue to produce gas is because they are producing natural gas liquids with it. The value of the liquids stream (propane, ethane, etc) is tied closer to oil prices or to other industrial / chemical demand (as in ethane). These companies will point out that even when their dry gas is just $3.00, the overall value of an mcf of gas includes the liquids that also get extracted, so they really get more like $5 per mcf produced. That is why they keep producing. The same goes for oil drillers in places like the Bakken, they are getting gas as a by-product, and starting to now sell it rather than flare it. A good Bakken well can put off 1-2 million cf of gas a day (2000 mcf). That is the equivalent of a good Marcellus shale gas well with a drill cost of $2mm...and the Bakken guys are getting it for free. With 200 rigs in the Bakken drilling 6 or more wells each a year, that alone would bring on enough gas to replace the 100 gas rigs that might drop out this year.

Meanwhile, companies like Chevron and Exxon continue to increase their production of natural gas, in part because they are learning to improve their shale gas techniques here in the U.S. in order to then transfer their knowledge to international locations where natural gas is very much in need, and selling at far higher prices. The gas market used to be dominated by the independent producers, who ramped up and slowed down drilling very quickly based on price changes. But you can bet the big guys react differently, and far more slowly, to price signals. Another reason gas prices won't revert as quickly in today's world.

So, will the chart revert to the mean? Probably, but it may take time. And the "new mean" may be something very different than the old mean...if you will allow me to play a bit loose with those definitions ;-) And when that happens, I believe we will more likely see crude oil come down, not gas come up. In 2008, I pointed out that we had finally turned the corner on gas production, and my investments started to avoid gas that summer added natural gas puts to take advantage of gas price drops. What I see now in oil is similar - we are creating more new oil supply than ever here in the U.S., and the technology is improving. The difference is that worldwide oil demand is something I continue to see growing, and I believe the new oil right now in the U.S. must replace all the dwindling supplies elsewhere (OPEC and Mexico, North Sea). I think this means we are still in an $85+ oil world, with spikes above that, and that U.S. production will grow, international demand will grow, and the U.S. will become less of an importer, at least in the next 4-5 years. This will dramatically help our trade deficit and I think it bodes quite well for our U.S. economy. The caution I advise, though, is that oil from formations like the Bakken, Eagle Ford, and Niobrara, may be more rare than the natural gas shale plays that have created an oversupply situation. A subject for another day: natural gas is actually being produced out of shale formations, while Bakken oil is actually being produced out of tight formations that are sandwiched between shale formations. Then there is another type of play whereby you "cook" oily shale, which is a different process altogether. Another day, perhaps...

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