Natural Gas Prices Show Oil Has a Long Way to Fall

Meredith Margrave's picture

Tuesday, July 7, 2009 - 2:55pm

by Meredith Margrave

Oil prices have dipped from their recent peak above $70 per barrel, and the price of another commodity suggests crude has farther to fall.

A barrel of oil contains 5.8 million British thermal units (BTUs) of energy. Natural gas is priced per million BTU. With that in mind, a barrel of oil should theoretically cost 5.8 times more than a unit of natural gas.  

That's theory. In practice, oil has historically cost more. Since 1994, a barrel of crude has cost 8.6 times the price of natural gas. Natural gas currently sells for $3.49 per BTU, implying a fair market value of $30.01 for a barrel of oil. Yet at current prices of around $64 per barrel, oil is trading for nearly 20 times the price of natural gas, more than twice its average.

Clearly, something's out of whack.

There are three ways prices could eventually normalize: Oil prices could fall, gas prices could rise, or the market could learn that the old ratio is broken and a new pricing reality is with us.

That last suggestion, that the old ratio has been rendered null and void by recent events, is the most dramatic explanation. It has some merit, because oil and gas can't be used interchangeably. You can't use crude oil to heat your home any more than you can put natural gas in your car. A user of one commodity can't take advantage of a price drop in another.

Given that, it's possible that oil and gas prices will never return to their historical trading ratio. But possible doesn't mean plausible, or probable, and it's unlikely that oil or natural gas will permanently depart from such a longstanding ratio.

That leaves two options: Oil prices could fall or gas prices could rise.

Conventional wisdom holds that the ratio will normalize when gas prices rise. Lately, investors have been piling into the U.S. Natural Gas Exchange-Traded Fund (NYSE: UNG). Assets in the fund, which invests in futures contracts, increased to more than $4 billion in June from less than $700 million in February.

That may come to be a regrettable position given new supply data. In June, the Potential Gas Committee, which monitors natural-gas supplies, announced that total U.S. underground reserves are fully 35% higher than previously thought. Much of that increase has come from advances in extracting natural gas from shale. That announcement of increased supply comes just as demand is falling due to a weak U.S. economy. With this as a backdrop, the price of gas isn't likely to move any which way but down.

Which brings us back to the first scenario: falling oil prices. By June 30, Oil rallied more than +100% from its Feb. 12 low of $33.98 per barrel, so the past couple of months have been great for anyone long on oil. That rise was substantially fueled by the belief that the global economy -- and, by extension, demand for crude -- would improve by the second half of the year. With the curtain having just fallen on the second quarter, it's looking like the recovery and the uptrend in oil might have been more wishful thinking than fundamentally driven.

In less than a week since its 2009 high, oil prices have already hit a 5-week low. Such price movements are a good indication that oil prices might have gotten ahead of themselves.

Bottom line: Oil's dramatic surge from its February lows has come to an end.

I predict that oil's recent downturn is the beginning of a long slide back to normalcy. Call it a trend, call it regression to the mean -- but it's happening.  Today's oil prices are too high relative to demand, and gas prices will be flat on over-supply and under-demand. My research is telling me that, for the price ratio to normalize, oil must fall, because gas can't go up.

Meredith Margrave does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.