The divergence between natural gas and oil prices continues to widen. Natural gas prices fell 32% last year, while crude oil rose 10%. The oil-to-natural gas ratio ended the year near a three-decade high. A barrel of oil contains about 6 million British thermal units (MMBTUs). Natural gas is priced in MMBTUs, so over a long time horizon one should expect oil to cost about six times as much as natural gas. Based on $100 oil, that would put the price of natural gas at over $16 per MMBTU versus today’s price of $3.
Natural gas prices have remained below their energy-equivalent price relative to oil for a number of reasons. On the most basic level, there’s more natural gas supply than demand. Since year-end 2005, U.S. dry gas production has increased by 25% compared to a 10% rise in consumption. The proliferation of shale gas production is, of course, the driving force here. According to IHS, shale gas now accounts for 34% of U.S. natural gas production compared to about 6% in 2006.
With output growth outstripping consumption growth, natural gas in storage has risen to a five-year high, pushing prices lower. But while prices have trended down for the better part of the last four years, firms have not yet cut back on production.
Click to EnlargeWhy aren’t natural gas companies reducing production in the face of falling prices? In the shale gas land rush in 2007 and 2008, some firms signed leases that require a company to produce or lose their lease. After sinking millions into leases, exploration and development, natural gas firms find it economical to continue producing as long as it’s cash-flow positive. Hedges entered into at higher prices and falling production costs have also allowed natural gas firms to operate at today’s lower prices.
In a perfect world, this excess supply of natural gas would be sucked up by consumers who are using oil at much higher costs on an energy-equivalent basis. The higher demand for gas and lower demand for oil would push natural gas prices higher and oil prices lower. In reality, consumers don’t yet have enough opportunities to substitute natural gas for oil. Oil is a global commodity, and its primary use is for transportation. Natural gas is still mostly a regional commodity, and few vehicles are equipped to run on natural gas or electricity (generated from natural gas).Building the Foundation for Greater Gas Demand
But abundant U.S. natural gas reserves and persistently low prices are beginning to catch the attention of business. Low natural gas prices are spurring investment in facilities that use natural gas to make chemicals, plastics, fertilizer and even steel. Liquefied natural gas (LNG) terminals that were built to handle natural gas imports are seeking approvals to export LNG. And the first two all-electric vehicles hit U.S. roads in 2011.
Higher natural gas prices would, of course, mean a bullish investor sentiment in natural gas stocks and funds. But higher prices aren’t a necessary condition to profit in natural gas shares. Rising production and falling costs can also increase the value of natural gas firms. Despite the downtrend in natural gas prices this year, PetroHawk was recently acquired by BHP Billiton (NYSE:BHP) at a 65% premium. And First Trust Natural Gas ETF (NYSE:FCG) was down only 8% in 2011 despite the poor performance in natural gas prices.
The opportunities for increasing substitution of natural gas for oil are finally starting to emerge. My investment case for natural gas may take some time to play out, but natural gas shares continue to offer profound opportunities for long-term investors.