The Ultimate Showdown: Crude vs. Nat Gas
Posted on: January 5, 2009 - Email Article - Printable Version
Many investors wonder whether or not there are advantages to being long or short one commodity versus another or if all commodities will roughly trade in the same manner. Like many of the other questions I tackle here on the website, there is no exact answer (as is the case with many questions dealing with the financial markets) to these questions. Even though there is no precise mathematical science to answer this question, there are many identifiable factors involved that can shed light on what to many seems to be a difficult and never-ending puzzle.
Two commodities which many inexperienced investors assume are very similar are crude oil and natural gas. In many cases, the difference between the use of and investments in these two commodities could not be more different. Crude oil is one of the base commodities that all investors follow, while natural gas is mistakenly tagged into conversations concerning crude oil because it also happens to be an energy commodity. The key to figuring out which can benefit your portfolio depends on your current allocation and macro-economic outlook.
Uses and Infrastructure Outlook
Crude oil currently is one of the most used commodities in the world, as almost every single nation around the world has a varying degree of crude oil “addiction.” Crude is used for everything from transportation to industrial processing to commercial products. Many consumers would be surprised to find out that petroleum based products include things as far reaching as women’s make-up. On top of this, the world’s economies have built both their discretionary and staple economic functions around crude oil infrastructure. Until this decade, excluding a few spikes in the 1970s and 1980s, this has not been a problem because oil was freely available. Most current estimates have crude oil contributing to over 40% of world energy consumption. However, there are no reliable numbers for world consumption.
Natural gas on the other hand is used more often for home heating, industrial production, and a few other commercial uses. It is also heavily used for electrical generation by utility companies. This gives natural gas a larger seasonality component, which I will get into later. Natural gas currently has less of an infrastructure built up in the United States, but aggressive capital expenditure programs by companies such as ConocoPhillips [COP: 50.85, +0.12 (+0.24%)], BP plc [BP: 56.04, -0.13 (-0.23%)], Chesapeake Energy Corp. [CHK: 25.70, +0.11 (+0.43%)] amongst many others are quickly changing that.
Advantage: Crude oil, for now. A return of high gasoline prices or new left-leaning legislation could change this going into the future.
Geographic Supply and Demand Functions and Seasonality
Both crude oil and natural gas have their own separate seasonality, and for more background on both of these commodities you can read The Fundamentals of Crude Oil Pricing and The Bullish Case for Natural Gas. Crude oil traditionally has had higher demand during the warmer months when driving is much more prevalent. Natural gas on the other hand has traditionally higher demand during the cooler months as home heating takes up a larger portion of energy consumption. Besides the difference in seasons, the other fact that separates crude and natural gas is that during the cooler months crude oil consumption does not decrease as rapidly as natural gas consumption does during the warmer months. This fact is very well known and priced into the futures through the backwardation and contango that we see so often in the NYMEX prices. Crude oil has less volatile supply and demand functions when compared to natural gas, and in turn the price movements of crude oil are generally less volatile than natural gas, which isn’t saying much, as crude oil is still very volatile.
Another important point to note is the geographic factors that affect crude oil and natural gas. Natural gas is traded in a number of different markets at different prices around the world. This is because it is impossible to move natural gas over seas without LNG tankers (Liquid Natural Gas tankers). Currently there are less than 200 full-size LNG tankers in the world, and the cost of building these LNG tankers is generally over $300 million per tanker. This transportation predicament can create wide disparagement in the price of natural gas across different continents.
Crude oil on the other hand, depending on the type, is traded at the same price all over the world. A large transportation infrastructure has been built around crude oil and it is very cheap and easy to move. Based on these factors, it is much more relevant to look at regional supply and demand for natural gas and global supply and demand for crude oil.
Advantage: Crude oil for inexperienced investors, natural gas for skilled and veteran investors.
Environmental and Political Outlook
Natural gas seems to be in favor with many powerful financial and political figures as of late. This is due to two main reasons:
- Natural gas on average produces only 60% of the “pollution” that crude oil does when it is consumed.
- There is an abundance of domestic natural gas available for exploration and production that will allow America to rely more on its own natural resources as opposed to the natural resources of other countries, specifically those that do not have aligned interests with the United States.
These two factors have convinced people including legendary oil man T. Boone Pickens, President-Elect Barack Obama, and even the automotive industry executives to push for natural gas as a way of the future. With probable legislation for increased carbon caps and environmental control, it seems that in many cases natural gas will be the logical substitution for crude oil as it is the only other commodity that can be produced on a wide enough scale to satisfy a large shift in demand. Many investors wonder about wind and solar, but the efficiencies of these processes will take 5-15 more years in order to compete with that of crude and natural gas. On top of that, it is easier to drill a well for oil or natural gas than it is to make a wind turbine or solar farm given the world’s current economic condition. Spare drilling rigs are fairly abundant in this economic downturn, but there are no such things as spare turbines or solar panels. There is no disputing that both wind and solar are environmentally superior to natural gas, but these two technologies are solutions to a future problem, not the current problem.
Advantage: Natural gas by a wide margin.
Relative Value
One of the most important aspects when analyzing crude oil and natural gas is the relative value of each commodity. There are two common ways that investors and traders use to determine relative value, but they are by no means the only two:
- Energy Output – The amount of energy output is referred to as BTUs, or British Thermal Units. This scientific measure allows us to compare different methods of energy consumption to see which is more efficient. The amount of BTUs contained in a barrel of crude oil is roughly six times as many as those contained in one of the natural gas units that are traded on the NYMEX exchange (this is measured in MMBTUs which stands for one thousand thousand BTUs, or one million BTUs). Using this method, it is possible to work backwards to see the relative value of both commodities. Using simple division we know that if this energy output ratio is greater than 6:1, then natural gas is relatively undervalued from an energy standpoint as the cost of one barrel of crude oil would be the equivalent of more than six units of natural gas. This also works in reverse. If the energy output ratio is below 6:1, then we know that crude oil is undervalued relative to natural gas as six units of natural gas would buy you more than one barrel of crude oil.
- Historical Trading Ratio – Over periods of time the actual trading ratio has more often than not been something besides 6:1. The reason for this is the infrastructure substitution effect. Because crude and natural gas cannot be substituted in every single circumstance, there must be a premium placed on the market ratio of the two prices. In the case of our modern day economy, the bias goes towards crude oil as our infrastructure is more heavily built around the consumption of crude oil. As you can imagine, large shifts in infrastructure may cause the trading ratio to change. This has happened multiple times in the past, but the last major shift occurred around the 1980s. Some investors believe that another shift may be coming due to new policies that could be put in place by the President-Elect Barack Obama. From 1980 till today, the actually trading ratio of a barrel of crude oil to natural gas has been averaging 8.5:1. The same math applies for this ratio as the energy output ratio, but the new “crude biased” ratio applies. Most of the energy traders and experts I have spoken to have used this historical trading ratio as opposed to the energy output ratio. Another important point to remember is that depending on your time period, the average historical trading ratio can change drastically. As you all have heard before, there are three types of lies: lies, damn lies, and statistics.
Using NYMEX prices from last week we can see the ratio stands at roughly 6.5:1 ($39 crude oil, $6 natural gas). By the energy output ratio, we would say that the commodities are both valued correctly relative to each other, but by the historical trading ratio we would say that crude oil is undervalued when compared to natural gas.
Advantage: Crude oil at the time of this writing, but shifts in relative valuation ratios takes place regularly.
Conclusion
All in all, it seems as if there is no clear winner to the battle. I’m going to award crude oil the temporary winner due to its infrastructure advantage, relative price, and the fact that it probably has less moving pieces involved for investors to analyze. Obviously, almost all of these variables I have written about in this and other articles are constantly moving, so it is important to be on top of the current macro and micro-economic news. Another important factor to remember will be the movements in the U.S. Dollar, although that won’t have an effect when analyzing crude oil and natural gas as they are both priced in U.S. Dollars (if you use the NYMEX gas prices). The key to successful commodities based investing is to be continually adapting to the new and ever-changing economic environment.
Winner: Crude Oil at the time of this writing.
- Charles W. Petredis
Disclosure: The mutual fund the author manages, the author, and the author’s family are all long CHK.
The Following Stocks Were Mentioned In This Article: BP, CHK, COP
Comments
Where do you see the trading ratio of Oil:NatGas going in the long run?
Is there any long term relative value (long/short) play to be had there?
Nice article
-Harry
Trading off this period over the long run is extremely difficult because the commodity prices can shift so quickly. Anything more than a 6 month to one year time frame would be tough unless you were using some sort of peak oil and natural gas model to predict future supply and demand.
In the short term crude looks pretty undervalued but the futures are priced into such a sharp contango that there may be no arbitrage possibilities available at this time, unless of course you are shorting crude.