Crude oil and natural gas are both energy commodities. We use these fuels to heat and cool our homes or supply other energy needs. The price link between crude oil and natural gas is an inter-commodity spread, which means that the prices between the two change in relation to each other.
In an inter-commodity spread, when one item costs more, the other becomes cheaper. Buyers are always seeking lower prices and higher supply.
How Are Crude Oil and Natural Gas Linked?
Many companies that produce crude oil also produce natural gas. Finding and producing natural gas and crude oil are often related. This is because the release and capture of natural gas can occur during the oil drilling process.
The link between crude oil and natural gas changed around the turn of the 21st century due to more natural gas reserves being found in the U.S.
Huge gas reserves newly found in the Marcellus and Utica shale regions of the U.S. changed the price relationship between crude oil and natural gas. The price of natural gas in the U.S. fell, while the price of oil kept rising between 2000 and 2014.
As the growth of emerging economies slowed and oil demand fell, the price of crude oil dropped drastically from late 2014 through early 2016. By 2018, the price of crude oil crept back up to over $70 per barrel, but due to the emergence of the coronavirus in 2020 almost halting demand for oil, crude oil prices dropped to historic lows. Natural gas dropped a little, but held pretty steady. As crude oil rebounded to over $92 per barrel by early 2022, the price of natural gas rose as well, but nowhere near as drastically as crude oil.
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 to 1 level. Oil trades in barrels. Natural gas trades in millions of BTUs (British thermal units or MMBtu). The ratio translates to 10 MMBtu of natural gas per one barrel of oil. For instance, if the ratio was still 10 to 1, and the price of crude oil was $40 per barrel, natural gas would be priced around $4 per MMBtu.
The price link between gas and oil traded to highs of more than 50 to 1 in March and April 2012. At that time, the price of crude oil was over $120 per barrel, and the price of natural gas was around $2 per MMBtu.
A return to pre-2009 norms started in 2012 when natural gas prices began moving higher. In 2014, when natural gas prices began to decline, crude oil prices fell even more on a relative basis. The bear market in crude oil, which took prices from over $107 per barrel in June 2014 to below $45 in March 2015, caused the spread to drop to around 16 to 1.
By April 2020, crude oil prices reached new lows as a result of COVID-19. Government orders to stay home sharply reduced the need for oil. At the end of April 2020, crude oil was priced at around $17 per barrel, while gas was priced at around $1.81 per MMBtu, bringing the spread to about 9 to 1.
On the futures market, each New York Mercantile Exchange (NYMEX) crude oil contract equals 1,000 barrels. Each NYMEX natural gas contract equals 10,000 MMBtu, but 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 in Competing Energy Products
Knowing about the price relationship between two commodities that compete for the same uses can provide you with clues to how future prices might look. When one commodity becomes more costly than the other, there is often a reason. In the case of oil vs. natural gas, it is usually supply and demand that drives the change.
Proven and probable reserves of natural gas cause a large price drop. This causes the inter-commodity spread to become wider than usual. A return to norms in inter-commodity spreads can also be the result of people using one in place of the other.
People will shun a costly commodity for a cheaper one. If oil prices increase, demand for natural gas will rise. This will cause a drop in oil prices and a rise in natural gas prices until the market gets stable once more.
The Bottom Line
The shifts in supply and demand can cause changes in price spreads. Watching how these prices relate to each other can help you become versed in price dynamics.
Inter-commodity spreads, such as the one between crude oil and natural gas, can be a vital asset to add to your commodity investment tool chest. They are another variable in the equations of investment science.