News

Oil to Gas Price Ratio: Which Direction is it Headed?

Natural Resources
0 min read

 

The Highest Ratio in 7 Years Between Oil and Gas Prices

 

A barrel of oil consists of 42 gallons and provides 5,712,000 BTUs of energy.  An MCF (thousand cubic feet) of natural gas provides 1,037,000 BTUs of energy. Both measurements depend on prevailing temperature, pressure, and fuel content. Still, the idea that a barrel of oil provides the equivalent of roughly six times the energy of natural gas is a long-accepted principle.  Management from the Energy industry and analysts often convert oil to natural gas equivalent volumes by multiplying by six or convert natural gas volumes to oil equivalent volumes by dividing by six.

If oil and gas were interchangeable fuels, it stands to reason that consumers would buy oil when it was less than six times the price of natural gas and buy natural gas when it was less than one-sixth the price of oil.  The ratio between oil and gas prices, then, would generally remain somewhere near that six to one ratio.  Historically, that has been the case. It has only been within the last ten years that oil has started trading at levels above 15 times natural gas prices.

 

 

Oil and natural gas are not true substitutes.  Oil is used predominately as a source for gasoline, and natural gas is used mainly for heating homes and businesses. Consequently, it is not unusual for the oil-to-gas price ratio to vacillate away from a six times ratio. Such was the case in 2011-2012 when the ratio reached 50 times, and such was the case in 2020 when the ratio reached 30 times. 

 

 

The pandemic and resulting global economic slowdown have caused both oil and gas prices to fall.  Oil prices have been hit especially hard, even dropping into the negative territory during April. Today, the ratio between oil and gas spot prices and that of the forward-twelve-month strip is closer to 15 times, near the low end of the last decade’s trading range.

So, is the current ratio the new norm? Or, Will the oil-to-gas price ratio rise back up to pre-pandemic levels near 30 times? Or, will the oil-to-gas price ratio revert back to historic levels below ten times and more in line with the ratio implied by the energy content of the fuels.

 

The Case for the Oil-to-Gas Ratio to Fall

The demand for oil for power generation is declining. The only area where oil and gas compete directly on the margin has been for electric generation load. That was, to say, until around the turn of the century. With the growth of renewable fuels as a source of generation, natural gas has become the fossil fuel of choice for power generation.  There are reasons for that.  Natural gas generally fuels smaller turbine power loads that can be powered up or down more efficiently than oil or coal.  Flexible power generation is a better compliment to renewable-fuel generation that is not always consistent.

 

 

Source: BP Amoco

The demand for oil for gasoline may decline. Electric vehicles are coming.  About 5% of the cars sold are electric, and that percentage is rising a few base points each year with growth rates accelerating.  California has mandated that all new passenger trucks sold in the state must be emission-free by 2035. Corporate Average Fuel Economy (CAFÉ) standards continue to rise. The result will be a decreased demand for oil to supply gasoline.

The pandemic is altering how people work and play. As people work and spend more time at home, there has been a surge in house sales and new home construction.  People want better and bigger houses. That could lead to an increase in natural gas demand and, thus, prices.  At the same time, people are commuting to work less often and spending less time driving to recreational events. This has reduced the demand for oil. The resulting decrease in demand for oil relative to gas could mean a lower oil-to-gas price ratio.

 

The Case for the Oil-to-Gas Price Ratio is Rising

Natural gas is becoming a more global fuel. Historically, oil prices were set by the global market, while natural gas prices were set by domestic supply and demand.  In recent years, natural gas has become a more global product with the growth of liquified natural gas (LNG) export terminals. The United States now exports more natural gas than it imports.  The chart below shows the rapid growth of U.S. LNG exports in recent years.

 

 

OPEC Has Gained Power to Set Oil Prices OPEC, led by Saudi Arabia, has become more active in controlling output levels and maintaining oil prices.  Should it continue to do so, it may support oil prices near current levels, even as natural gas prices continue to fall with production technological advances.  The result would be a higher oil-to-gas price ratio.

 

Conclusion

The historical ratio between oil and gas prices has been broken in recent years as the fuels are used less outside their primary markets. It is unreasonable to expect the ratio to return to six times just because the relative energy content says that what the ratio should be.  On the other hand, the long term outlook for oil demand relative to gas demand argues for the ratio declining from its current level.

 

Suggested Reading:

Have Wind and Solar Made Hydro-Power Irrelevant?

Mergers Within The Energy Industry are Heating Up

Exploration and Production: 2020-3Q Review and Outlook

 

Enjoy Premium Channelchek Content at No Cost

 

Each event in our popular Virtual Road Shows Series has maximum capacity of 100 investors online. To take part, listen to and perhaps get your questions answered, see which virtual investor meeting intrigues you here.

 

Sources:

https://en.wikipedia.org/wiki/Corporate_average_fuel_economy#:~:text=The%20Corporate%20Average%20Fuel%20Economy,sale%20in%20the%20United%20States, Wikipedia

https://www.cnn.com/2020/10/03/cars/california-2035-zev-mandate/index.html, Peter Valdes-Dapena, CNN, October 3, 2020

Photo: A natural gas and conventional oil electric power generating station located on the north shore of Long Island (Northport).

Share

Inbox Intel from Channelchek.

Informed investors make more money. And it’s all about timing. Get it when it happens.

By clicking submit you are agreeing to the Terms of Use and Privacy Policy
© 2018-2024 Noble Financial Group, Inc. All Rights Reserved. Channelchek is provided at no cost to be used for information purposes only and not as investment advisement.