Oil/ Natural Gas Disparity

Posted on June 12, 2009 by David Laidlaw 

A 42 gallon barrel of oil has the same energy content as roughly 6,000 cubic feet of natural gas. Given this equivalence, one would assume that the market price for these two hydrocarbon resources would be about the same. However, oil is roughly three times as expensive as natural gas now.

Price differences between these commodities could arise for a number of reasons. Oil is literally and figuratively a more liquid commodity. Once pumped out of the ground in Mid-East, Africa or North America, oil can be transported anywhere in the world through a network of pipelines and tankers. Natural gas is a much more local commodity and is mainly transported via pipelines. Natural gas can be converted to a liquid state (liquid natural gas or LNG) and shipped similar to oil; however, there are a number of hurdles to this process including restrictions in this country that limit the building of LNG processing facilities in our coastal areas due to environmental concerns. The fact that oil is easier to transport suggests that it deserves a slight premium to natural gas.

On the other hand, natural gas is a cleaner fuel than oil.Burning natural gas produces less nitrogen and sulfur oxides than oil and is better for the environment since smog is reduced per unit of energy produced.

Over the past 15 years, the price of natural gas has fluctuated between 30% and 200% of the price for oil. During this period, it has averaged about 75% on a monthly basis. Right now, natural gas is very close to an all-time low selling for 35% of the price of oil. The low price of gas relative to oil suggests that either oil is too expensive, natural gas is too cheap or a combination of the two.

Over time, we believe that natural gas will increase in price relative to oil. The main mechanisms by which this will occur are demand substitution of gas for oil at the margins and supply expansions of oil relative to gas. Utilities that use both oil and natural gas have a strong incentive to substitute natural gas for oil since it is much more cost effective. Boone Pickens, energy magnate, is lobbying the government hard to convert cars to natural gas to decrease our reliance on foreign oil. These efforts may tip the balance toward natural gas in the distant future, but are by no means assured. Energy suppliers will focus more on oil production since it garners a much higher price in the marketplace so that the supply of oil should increase at a faster rate than the supply of gas. Regardless of how the change in the intersection between supply and demand occurs, the relationship between oil and gas prices will revert closer to parity.