The note below is from our recently-launched energy Sector Head, Lou Gagliardi. If you'd like to trial his energy sector research, which includes access to the replay of his launch presentation on natural gas, crude oil, and opportunities in the global E&P sector, please email .
Conclusion: We believe that historical levels of the crude oil to natural gas ratio will not be revisited. Crude oil will remain in the new normal range versus natural gas of 14 – 18x, and thus not return to the historical average of ~10x, which would imply $40/barrel oil at current natural gas prices.
We looked at the historical relationship of oil to gas prices since 1994, on oil to gas “fundamental” multiple basis based on the historical average, oil would be trading at an average price of ~$40/bbl. But we don’t think the probability of that occurring is high, particularly since crude oil’s emergence as a “trading” financial asset over the last few years, and the willful, or not, of the debasement of the U.S. currency through extraordinary liquidity injected into the U.S. monetary system and the ensuing ballooning of our fiscal deficit. In effect, a weak U.S. dollar equals higher oil prices.
From 1994 to today, the price of WTI (West Texas Intermediate) crude oil and HH (Henry Hub) natural gas has averaged ~$40.70/bbl, and $4.55/Mcf, or at an average oil to gas multiple a shade over 9 times, which is close to the Btu equivalent of 6 times oil to gas. In contrast, the average multiple for 2010 year-to-date is about 17 times, as natural gas has dropped and oil has remained above $70/bbl, whilst the U.S. dollar has remained weak relative to the Euro. The average standard deviation for each year since 1994 has been just under 2 times, year-to-date for 2010 it is 2.3 times. So it appears that the volatility in the relationship has returned to its historical mean.
Over the last few years, we have seen crude oil traded increasingly as a financial asset, which has created incremental demand for crude oil. In addition, the general decline of the U.S. dollar over the last few years has led to an increase in crude oil since it is priced in U.S. dollars. But not all of the price increase in crude oil is attributable to its relationship to the U.S. dollar, or financial demand. In fact, a fair portion of its meteoric rise in price is due to fundamental structural imbalances and deficiencies in the supply/demand equation.
There are many fundamental factors from rising Resource Nationalism across the globe, to the acceleration of the developing world’s industrialization, i.e., China, India, Brazil, Russia, to insufficient energy infrastructure, to geopolitical instability, to rising lifting and finding & development costs, to insufficient excess supply capacity, which all have fueled crude’s rise upward. Indeed, increasing supply constraints due to declining production from major oil producing regions from Mexico, Venezuela, Alaska North Slope, North Sea, to Canadian Conventional, and the lower U.S. 48, have exerted upward price pressure on crude prices. While there does not appear a high probability of oil prices returning to $40/bbl for a sustained period, it does appear that the price of oil pegged to supply and demand has shifted higher on an energy equivalent basis vis-à-vis natural gas. This is in line with our long-term TAIL bullish outlook for oil.
A counter weight to the oil to gas multiple remaining higher could be the price of natural gas. Our outlook is bearish for natural gas over the intermediate term trend, driven by drilling technology ahead of supply needs; we believe that increasing natural gas supply will compete away some crude oil usage in areas where oil is used as a commercial fuel source. Increased switching to natural gas as a commercial fuel source away from crude oil due to its low gas price could exert some modest downward pressure to crude prices from a fundamental basis in the intermediate term. But, in the long term, crude oil supply constraints will continue to pull crude prices higher. The wild card in the oil to gas multiple will remain the U.S. dollar driven by U.S. monetary policy and global deficit spending. So watch the multiple, long-term we expect it to stay wider than historical levels as we enter the new normal of natural gas and crude oil energy equivalency.
From the Oil and Gas Patch.