Crude Oil vs. Natural Gas
Crude oil and natural gas are both energy commodities. As such, we use these fuels to heat and cool our homes or supply other energy needs. The price relationship between crude oil and natural gas is an inter-commodity spread, in which the prices between the two change in relation to each other.
Historically, in an inter-commodity spread, when one becomes more expensive, the other will be more desirable for consumers because of the lower prices and higher supply.
The Relationship Between Crude Oil and Natural Gas
Many companies that produce crude oil also produce natural gas. Natural gas and crude oil exploration and production are often related because the release and capture of natural gas can occur during the oil drilling process.
As related energy commodities, the prices of oil and natural gas have a certain historical price relationship. However, that relationship changed around the turn of the twenty-first century due to the discovery of more natural gas reserves in the United States.
Huge natural gas reserves, previously undiscovered in the Marcellus and Utica shale regions of the United States, altered the price relationship between these two energy commodities, lowering the price of natural gas in the U.S. while the price of oil continued to rise between 2000 and 2013.
Attributed to slowing growth of emerging economies and a reduction in oil demand, a drastic drop in the price of crude oil occurred in late 2014, continuing through early 2016. This created the effect of returning the price relationship between the two commodities to more normal historical levels.
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 trades in millions of Btu's (British thermal units or MMBtu). The ratio translates to 10 MMBtus of natural gas per one barrel of oil. If the price of crude oil is $40 per barrel, a price of around $4 per MMBtu for natural gas would be implied (close to pre-2009 norms).
On the futures market, each New York Mercantile Exchange (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. 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 below 16 to 1.
Understanding the Price Relationship in Competing Energy Products
Understanding the price relationship between two commodities that compete for the same uses can provide important information and clues to future price direction. When one commodity becomes more expensive than the other, there is often a reason for the price divergence. In the case of oil vs. natural gas, it is usually supply and demand that influences the change.
Proven and probable reserves of natural gas cause a dramatic price drop—this causes the inter-commodity spread to become wider than usual. A return to historical norms in inter-commodity spreads can also be the result of substitution when consumers use one in place of the other.
Consumers, who tend to make wise economic decisions as a group, often shun an expensive commodity or raw material for a cheaper substitute. If oil prices increase, demand for natural gas will increase, causing a drop in oil prices and a rise in natural gas prices until the market stabilizes again.
Some Final Thoughts
The shifts in supply and demand can cause changes in inter-commodity spreads. Watching these price relationships can help an investor or trader understand price dynamics.
Therefore, inter-commodity spreads such as the one between crude oil and natural gas can be an important tool to add to your commodity investment tool chest. These spreads are another variable in the equations of investment science.