The oil price is soaring whilst the gas price has plummeted. Something has to give.
So many extraordinary things happened in 2008: the effective failure of Northern Rock, Royal Bank of Scotland (LSE: RBS) and HBOS, extreme currency dislocations, and crazy stock price volatility, just to name a few. Yet while most of us were glad to leave the Year of the Black Swan behind, I think I've spotted another blackbird in the relationship between oil and natural gas.
At a fundamental level, different forms of energy should be fungible. Oil, natural gas, coal, and other fuels all produce a certain amount of energy. Moreover, with varying degrees of difficulty, you can often turn one energy commodity into another, or substitute between the two in various applications.
For instance, you can make diesel fuel and natural gas from coal, or you can choose a furnace that runs on heating oil or natural gas. These facts should tie energy prices of different commodities to each other, which is why the recent relationship between oil and natural gas boggles the mind.
Gas Price Up or Oil Price Down?
Between 2001 and 2008, the ratio of the price of oil to the price of US natural gas stayed roughly between 6 and 15. Ordinarily, things like cold snaps and other weather-related phenomena, as well as supply issues, can push one commodity's price higher relative to the other.
But recently, the ratio of the front-month contracts of oil and natural gas rose to over 27. By my calculations, that qualifies as an extremely rare six-sigma event based on past moves in the oil-to-gas ratio.
The conclusion here is that either natural gas will rally, or oil will sell off, or both. Whatever the combination, statistically, natural gas is in uncharted territory relative to oil.
Why Is This happening?
There are plenty of theories as to why oil and gas have moved out of lockstep. Huge gas finds from shale have driven supply upward to the point where available storage is almost full. But many sources of energy consumption, such as cars, still rely almost entirely on oil.
While Honda already has a natural-gas powered car and Toyota has announced plans to develop a natural-gas hybrid vehicle, converting many forms of oil-based consumption to natural gas will take time, suppressing demand during the switchover.
In addition, energy speculation may play a role. Recently there have been calls for ways to limit speculators trading energy futures. Yet while some point to higher oil prices in recent months as evidence of speculation, the gas market certainly shows a different picture.
If anything, the opposite seems to be true with natural gas: The US Natural Gas ETF is currently priced at almost a 10% premium to natural gas positions it holds, and it has chosen not to issue new shares in light of worries that new regulation will make it impossible for the ETF to meet its investment objective.
Natural gas is more difficult to store than oil and much more difficult to move around. For the most part, unless you have an expensive pipeline, there isn't much you can do when demand is weak. As of the end of August, US natural gas futures had dropped 47% in 2009 as the worst economic slowdown since the Great Depression cut factory and power-generation demand, which resulted in record stockpiles.
A Turnaround
Supply and demand inevitably pull back into equilibrium, though. The number of drilling rigs has fallen 56% from last year's peak, and the economy seems to be stabilising.
In terms of natural gas producers, here in the UK, there aren't many obvious plays. BG Group (LSE: BG) is the big daddy, but it is hardly cheap, trading on a P/E of around 15 and a dividend yield not much above 1%.
A smaller player like JKX Oil & Gas (LSE: JKX) might be worth a look, although be warned some of its assets lie in the politically volatile Ukraine, perhaps explaining why the shares trade on a seemingly modest P/E ratio.
Volga Gas (LSE: VGAS) is a Russian oil and gas exploration and production company. The shares have been on a tear this year, up close to 500% from their low point. Helping put a rocket under the shares has been the anticipation of the drilling of Volga's first deep sub-salt exploration well in its Karpenskiy Licence Area in Russia. If the well is successful, the CEO says it will be transformational for the business and firmly establish Volga Gas as a significant operator in the region.
The extreme relationship between oil and natural gas is likely to resolve itself soon. As I see it, shares with natural gas exposure should continue to do well as prices get back in line. Our oil & gas discussion board is always an excellent resource for share ideas and discussion regarding this sector.
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> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who doesn't have an interest in any of the companies mentioned in this article.
