Demystifying the Commodity Crescendo

Crude Oil and Natural Gas Spread Widening

If you’ve been following the commodity market recently, you most definitely will have heard that the historically consistent multiple between crude oil and natural gas forward contracts is widening. This sudden change in the trend of this multiple is quite telling of industry fundamentals.

The Multiple over Time

Recent Behavior

Why do crude oil and natural gas prices generally follow each other at a consistent multiple? The answer lies in the science.

The heating value of a barrel of crude oil and six million British thermal units of natural gas are effectively the same. Logic tells us that if two things do exactly the same thing they should be priced equivalently. What we should see then is that the multiple between a barrel of crude oil and one million British thermal units of natural gas to be approximately 6x. Over the past ten years, however, this multiple has averaged approximately 8.3x. But why?

Luckily I have a friend who asked this question of energy expert Peter Tertzakian at the International Student Energy Summit in Calgary, Canada, a few weeks ago. Tertzakian’s paraphrased answer to the question was, “In a perfect world where all sources of energy are completely substitutable, pricing would be based on energy content and efficiency and would essentially be equal across the board. However, because our society and infrastructure does not allow all energy sources to easily be substituted in and out, we experience decoupling in pricing. The oil and gas differential has a great deal to do with transportation. Because our infrastructure is set up around petroleum and is not easily changed away from this, it is valued differently.”  In other words, Tertzakian is saying that the transportation infrastructure (pipelines, etc.) currently in place is made for petroleum products not natural gas.

What Tertzakian’s answer doesn’t explain, though, is why the spread has shot up to 19x in the past few weeks. The answer to this question lies in the fundamentals (or lack thereof).  First, a disclaimer: The commodity market is broken and therefore can be quite deceiving. But that’s a discussion for another post.

Let’s look at crude oil. On the long-term fundamental side, oil is getting more difficult and more expensive to find, develop, and produce. (Don’t worry, we’re not running out; it’s just harder to get at.) The Canadian oil sands are an excellent example of the increase in cost of marginal price per barrel of oil. New oil sands projects have breakeven points in the range of $70-80/bbl. The resource is vast; it’s just expensive to produce. Shell recently reported that 10% of their new production had average breakeven points over $70/bbl. Add to that speculation that the U.S. recession is nearing an end driving up forward contracts as demand is expected to rise in the near future, and you have sharply rising oil prices.

Natural gas is a different story. Over the past decade, there have been major technological advances in natural gas transportation and recovery. Transporting natural gas long distances (i.e. across oceans) has become much easier with advances in liquefied natural gas (LNG) technologies. Now not only can the U.S. get its natural gas from pipeline-able locations like Canada, but from any location in the world—increasing supply. Similarly, there have been major technological advances in recovery of what is known as shale gas—again increasing supply. Basic economics tell you that as supply increases (without an increase in demand) prices will fall. This long-term fundamental change combined with increased U.S. natural gas inventories due to increased drilling in 2007 and 2008 has driven natural gas prices down.

Fundamentals and consumer sentiment are driving crude oil prices up and natural gas prices down: that’s why we see the multiple increasing to unseen levels.