Crude Oil Versus Natural Gas: Competing Energy
Crude oil and natural gas are both energy commodities. As such, we use these fuels to heat or cool our homes. The price relationship between crude oil and natural gas is an inter-commodity spread. When one gets more expensive on a historical basis, consumers have the option of switching to the other, particularly when it comes to heating. Often natural gas and crude oil exploration and production are related.
The release and capture of natural gas can occur during the oil drilling process. Oil, petroleum or hydrocarbon reserves are often located deep in the crust of the earth. Cracks in the earth's crust can trap natural gas. Drilling oil wells often release natural gas reserves.
The Companies Involved in Crude Oil and Natural Gas
Many companies who produce crude oil also produce natural gas. As related energy commodities, the prices of oil and natural gas have a certain historical price relationship. However, that relationship has changed in recent years due to the discovery of new natural gas reserves in the United States. Huge natural gas reserves discovered in the Marcellus and Utica shale regions of the United States have altered the price relationship between these two energy commodities. With a drop in the price of crude oil in late 2014 and 2015, the price relationship between the two commodities has returned to more normal historical levels established over the past twenty-five years.
Average Price Relationship Between Natural Gas and Crude Oil
Up until 2009, the average price relationship between natural gas and crude oil was around the 10:1 level. Oil trades in barrels while natural gas in millions of Btu's (British thermal units or mmbtu). The ratio translates to 10 mmbtu's of natural gas per one barrel of oil.
Think of it this way, if the price of crude oil is $40 per barrel that would imply a historical norm (pre-2009) of around $4 per mmbtu for natural gas.
On the futures market, each NYMEX crude oil contract represents 1,000 barrels while each NYMEX natural gas contract represents 10,000 mmbtu. However, the prices quoted for each on the futures exchange represent the price of one barrel of crude oil and one mmbtu of natural gas. The price relationship between the two energy commodities traded to highs of more than 48 to 1 in March 2012 when the price of crude oil was over $110 per barrel and the price of natural gas was around $2.30 per mmbtu. A dramatic return to long-term pre-2009 norms occurred starting in 2012 when natural gas prices began moving higher. Even though natural gas prices moved lower, crude oil prices fell even more on a relative basis. The bear market in crude oil, which had taken prices from over $107 per barrel in June 2014 to below $45 in March 2015, caused the spread to drop to below the 16 to 1 level.
Understanding the Price Relationship in Competing Energy Products
Understanding the price relationship between two commodities that compete for the same use can provide extremely important information and clues as to future price direction.
When one commodity becomes more expensive than the other does, there is often a reason for the price divergence. In the case of oil versus natural gas, it had to do with supply issues. Proven and probable reserves of natural gas caused dramatic price drop which caused the inter-commodity spread to move much higher than historical norms. A return to historical norms in inter-commodity spreads can be the result of substitution . Consumers, who tend to make wise economic decisions as a group, often shun an expensive commodity or raw material for a cheaper substitute. As you can see, shifts in supply or demand can cause changes in inter-commodity spreads. Watching these price relationships can help an investor or trader to understand price dynamics. Therefore, inter-commodity spreads like the one between crude oil and natural gas can be an important tool to add to your investment tool chest.
These spreads are another variable in the calculus of investment science.
Information on supply and demand for both crude oil and natural gas including inventory levels and other supply and demand data for each market is available free of charge from both the American Petroleum Institute and the Energy Information Administration in the United States.