HardAssetsInvestor

Written by Brad Zigler  |

August 29, 2008

Spreading Oil And Natural Gas

Details

HardAssetsInvestor.com's managing editor delves into whether natural gas prices are cheap relative to crude oil.

• Differing pricing conventions
• Reducing crude's value to its energy equivalence
• Seasonal variables

 

For workaday stiffs like me, Labor Day picnics and barbecues are a coda for the lazy, hazy days season and signal the approach of cooler weather and heating bills. Lest that thought put a chill into your holiday plans, let me offer a trade idea with wallet-warming potential.

A recent Wall Street Journal article reported that natural gas prices are cheap relative to crude oil. The article's expert sources claim, in fact, that natural gas futures are trading at some of the steepest discounts seen in several years.

Now, it's not easy to judge the relative value of these fuels due to their pricing conventions. Oil is priced in dollars per barrel, while natural gas is denominated in dollars per million British thermal units (mmBTU). One way to rationalize prices is to reduce crude's value to its energy equivalence. One barrel of crude, on average, supplies 5.8 mmBTU. Divide crude's price by 5.8 and you'll see its thermal energy value.

 

Energy Equivalence 

As an example, NYMEX spot crude closed at $115.29 per barrel on August 28. The contract's energy- equivalent price was $19.88 per mmBTU. Meanwhile, the nearby natural gas contract settled at $8.05 per mmBTU, the energy equivalence of crude at $46.69 per barrel. From this perspective, natural gas is selling for 41% the price of oil.

According to the expert quoted in the Wall Street Journal piece, the gas discount, given current supplies, ought to be at the 60-70% level. The Journal cites new production technologies increasing the pace at which gas can get to market while demand growth slows. All of that, it seems, has widened the discount.

Naturally, there are times when natural gas provides BTUs cheaper than crude and, at other times, at a higher cost. Since 1994, crude has traded at a premium as large as $13.11 per mmBTU, or $76.04 per barrel-equivalent, to a discount of $5.41 per mmBTU ($31.40 per barrel-equivalent).

Going into the fall, crude oil typically commands an energy-weighted premium over natural gas, but that usually wanes as winter approaches. In other words, natural gas prices tend to approach - and sometimes, surpass, those of crude oil in the cold weather season.

 

Crude Oil/Natural Gas Spread ($ per mmBTU)

 

Intuitively, that makes sense. After all, gas demand tends to be highest in winter and while refiners' demand for crude diminishes. Annual maintenance programs usually shutter refineries in the winter. Increased gas demand keeps price firm while a slack market for crude allows prices to languish.

We've discussed petroleum market seasonality in several Hard Assets Investors articles, including "Time For Crack Spreads?". Speculators typically buy the spread (long crude oil/short refined products) on Hallowe'en and hold the position until mid-December.