Why Natural Gas is Set to Soar in 2011 (Hint: Oil-to-Nat Gas Ratio is Out of Whack)

Natural gas is starting to get some contrarian love as a possible hit in 2011.  It's price action is starting to look favorable, as it looks like "The Natty" has finally put in some sort of bottom.  For a look at oil and gas fundamentals - including the important oil-to-natural gas ratio, here's our energy guru Marin Katusa for a look...
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Where Are Oil and Gas Prices Heading Next?
By Marin Katusa, Chief Energy Strategist, Casey Research

Oil is heading to US$200 per barrel. This isn’t speculation but hard fact. But forewarned is forearmed, and with this price expected within the next five years, investors have plenty of time to position themselves.

We recently have been talking about tools that investors can use to navigate the economic landscape. The gold-to-oil ratio is one such tool, but another popular compass is the oil-to-natural gas ratio.

The oil-to-natural gas ratio relates more to nuances within the energy complex, rather than the gold-to-oil ratio, which relates to monetary values. It’s the WTI Cushing price of crude oil per barrel to the Henry Hub Spot Price for natural gas per million thermal units.

In theory, based on an energy equivalent basis, crude oil and natural gas prices should have a 6-to-1 ratio. Market characteristics, however, have dictated that since 2006, the price of oil follow a pattern of 8-12 times that of natural gas.

As the chart below shows, historically the oil-to-gas ratio from 1990 to 2008 was in the low 9s. This means one barrel of crude oil was equivalent to about 9,000 cubic units (Mcf) of natural gas.

Improved drilling techniques and access to immense shale gas fields across the country have seen a boom in domestic gas production. Nor can gas wells just be shut down willy-nilly. The complexities of a gas well mean that it takes anywhere between three to six months to shut down operations.

And while the number of rigs sprouting up each year is decreasing, natural gas production is on the rise, with many of the shale wells coming online with their sources fresh and untapped.

Thanks to this flood of shale gas, the oil-to-gas ratio has risen to almost 17 on average. That is, one barrel of oil is now worth 17 Mcf of natural gas (17,000 cubic feet of gas)!

When we defined the oil-to-gas ratio, we used the term “thermal units.” It is interesting, then, that based on thermal units, one barrel of oil produces as much energy as roughly 6 Mcf of natural gas. So from a financial perspective, the oil-to-gas ratio is very different than in terms of energy.

Some companies and analysts use this disparity to their advantage, using the 6 instead of the 17 value to come up with the “barrels of oil equivalent” conversion for the value of gas. That’s a fudge factor of 2.8!

It’s an accounting mechanism that’s been turned into a completely legal but very shady promotion mechanism, one we watch for carefully.

It’s worth knowing that things can change very rapidly in the natural gas market. We do believe, though, that the current trend will continue for years to come, with the oil-to-natural-gas ratio ranging between 15 and 20.

For long-term investors, the oil-to-gas ratio is indicative of a paradigm shift in the markets. It is yet another tool in our collection of crystal balls for the economy and, if read correctly, is a great way to add some valuable holdings to a portfolio.

(Fortunately, you don’t need a crystal ball to profit from energy. All you really need is a subscription to Casey’s Energy Report, which you can try for three months, risk-free, by clicking here now.)

Ed. note: I am a Casey Energy Report subscriber and affiliate.

Natural Gas Falls Below $3! Why This May Not Be The Bottom.

Raise your hand if, a few years ago, you thought you'd see Natural Gas trading below $3 ever again. I never expected it. Yet here we are, just a few years after there was talk of "Peak Nat Gas" in North America, with the Natty sliding below $3.

And what a slide it's been!

Turns out the cure for high prices was high prices.

(Source: Barchart.com)

This is why I don't have a hard time seeing crude oil back in the $20's or $30's at some point. Peak Oil guys will get red in the face, saying how it's impossible. In fact, check out the angry commenter on this $20 Oil post, who called me a Moron!

Now he may very well be right - but I can't help but wonder that if high prices can bring so much Nat Gas on the market, what's so different about oil?

What's the downside on Natural Gas here? Obviously pretty limited - at most it's $2.90! Not a bad lottery ticket to think about playing with hurricane season rolling around. Though I'd like to see some more negativity on this as a speculation, before I think about trading it myself.

Ever since the Natty broke $5, we've been hearing how cheap it was, how it's a great speculation at these prices. Then it broke $4. Now it broke $3. Let's see it break the back of a few more bulls before we take a look at this as a speculation.

Huge Oil Inventories Just Reported

This morning, the US Department of Energy reported, well, HUGE inventories in oil. Oil's decline hastened on the news.

I'm wondering if oil has placed in its short term top, on it's way back down to the $40 range, or perhaps lower (maybe even $20 as predicted here?)

After rallying north of $140 last summer, oil will post a decidedly "lower high" if we have indeed already seen the short term top in the black goo. Whether or not it posts a lower low remains to be seen, but I wouldn't rule it out.

Many folks get outright pissed if you suggest that oil could fall...in fact a recent outraged commenter referred to me as a "moron."

Now that very well may be the case, but let me ask, who could have pictured $3 natural gas, when prices looked like they'd never dip below $10 again, and everyone was talking about Peak Drilling in North America?

Peak Oil is not as scary when demand evaporates faster than supply comes offline. Sure, things may get ugly again if and when the global economy actually recovers, but that won't help your portfolio in the interim. If you're thinking long term, I commend you, that's just not for me any longer.

And remember that the last time oil rolled over, the equity markets were soon to follow. It will be interesting to see if a top in oil again precedes a stock market collapse.

Further reading: An energy executive shares his insights on where the price of oil should be.

Hat tip to The Daily Crux for digging out this link.

What's the Deal With Natural Gas - Is It Cheap, or Not?

It seems like these days, EVERYONE is looking a natural gas prices, wondering "how could they be so low?" As recently as a few years ago, "The Natty" was selling for over $16 - how could it now be languishing just above 3?

It's often said in the commodity world that the best cure for high prices is high prices. That's exactly what's happened in the natural gas market, as North America's "peak natural gas" situation has been reversed by the miracles of innovation.

The free market solving our energy needs - what a novel idea, huh!

So if the cure for high prices is high prices, is the reverse also true? Is natural gas destined to bounce back, as suppliers inevitably turn off production that is no longer profitable. Read on to find out in this excellent piece, shared with us by noted guest author David Galland...

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Is Natural Gas Cheap?
By David Galland, Casey Research

At the height of its late 2005 rally, natural gas in the U.S. was selling for just over $16/MMBtu, 350% higher than today’s price of $3.56. The oil/gas ratio, now over 18, is an all-time high… suggesting that natural gas is dirt cheap. So, it’s a buy, right?

In a phrase, not exactly.

According to a recent report by Natural Gas Intelligence, U.S. natural gas available for production “has jumped 58% in the past four years, driven by improved drilling techniques and the discovery of huge shale fields in Texas, Louisiana, Arkansas and Pennsylvania, according to a report issued Thursday by the nonprofit Potential Gas Committee (PGC).”

According to the report, the increase in gas discoveries and production improvements means that North America shouldn’t have to be concerned about gas supplies for up to 100 years!

Dr. Marc Bustin provided an overview of the situation in the May edition of Casey Energy Opportunities.

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In the United States, the tremendous growth in natural gas resources and estimated recoverable natural gas, particularly from gas shales, just in the last two years (Figure 1) is sending tremors through the entire industry. These tremors include the risk of making obsolete the proposed $26 billion Alaskan and $16 billion northern Canadian pipelines to tap northern gas resources and a slue of proposed LNG terminals... unless they are for export!

The numbers currently kicked around are that something around 2,000 trillion cubic feet of gas are technically recoverable in the United States. At current production rates, this supply would last about 90 years.

Some analysts are predicting that even if the U.S. economy recovers in the next year, the amount of gas discovered to date in gas shales will severely dampen any increase in gas price for some time. According to a new study by energy consulting firm CERA (Cambridge Energy Research Associates), new technologies for unconventional gas fields are being applied so successfully that supply is essentially no longer a driver in either production or price in the North American gas market – whatever the market wants, North American gas fields can supply. CERA reports that natural gas production in the Lower 48 states has risen a startling 14% from 2007 to 2008, for example.

Major shale areas or formations in the U.S. and the estimated recoverable natural gas in 2006 and 2008. Modified from Daily Oil Bulletin (May 4, 2009).

Given the increase in production and the small slide in demand, the price of natural gas has fallen to around $3.50-$4.00 per MMBtu (down from $13 per MMBtu last summer). At these prices, many gas prospects are uneconomic, and thus there has been a marked decline in the number of wells being drilled. Rig activity (how many rigs are operating) is down about 50% in North America.

But here is where an interesting feedback mechanism kicks in. One of the characteristics of unconventional shale gas wells, and to a lesser extent natural gas wells in general, is that the production rate declines through time. Most shale wells’ production rates decline 60 to 90% in the first year. If you were a gas company trying to survive amidst today's low prices, the rate of return on your capital investment would also be painfully low for a significant amount of gas if this were your initial year of production.

Another complementary fact is that over 50% of natural gas consumed in the United States today is from wells drilled less than three years ago, and 25-30% of the gas produced today comes from wells drilled last year (Figure 2).

Hence it follows that if there are 50% fewer wells drilled this year (from the drop in rig activity), new production will decline about 35-40% by the end of the year, so there will be gas shortages. Those will in turn lead to higher North American prices, which in turn should lead to additional drilling.

Historical gas production in the U.S. showing the percentage of production from vintage of well (modified from Chesapeake April 2009 Investor presentation from original data of HIS Energy)

Everything else being equal (which it's not, this being the real, not the mathematical world), gas prices and drilling will see-saw until an equilibrium is reached. In detail, of course, things are more complicated, but it is pretty clear that gas prices will have to rise within the year, and the big losers will remain the more expensive plays that require higher gas prices to be economic.

Where will the gas price end up in the short term? A poll of analysts by Reuters suggests $6 MMBtu in 2010 (Daily Oil Bulletin, May 4, 2009), but I don’t think I would bet on a gas price based on a vote by analysts. At the same time, it's an interesting coincidence (or not – coincidence, that is) that many prospects become economic at around the $6 MMBtu range. Among them are the Haynesville and Marcellus shales – and it's no large leap from there to see their tremendous gas production potential acting as a buffer to gas prices going much higher in the near term.

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Thus, while there may be some seasonal and relatively short-term trading opportunities in natural gas, the overhang of ready supply places a fairly firm cap on the price. Which begs the question, which big-trend energy opportunities should be getting our attention today?

Marin Katusa, who heads the Casey Research energy team, answers the question by, correctly, cataloging the opportunities according to geography.

In North America:

1. Geothermal -- the most interesting of the alternative energy sources, by a wide margin.
2. Nuclear.
3. Oil.

In Europe:

1. Unconventional gas has, by far, the most upside.
2. Unconventional oil.
3. Small hydro (such as run of river).

In Africa:

First and foremost, you want to avoid infrastructure plays (pipelines, refineries, etc). Then you want to look for areas with huge oil potential, which have been held off the market by concerns over political risk. I like what Lukas Lundin is doing in Ethiopia, Somalia, and Kenya, hunting for “elephants” with the idea of eventually selling the discoveries off to the Chinese.

In Asia:

1. Liquid Natural Gas (LNG)
2. Coal Bed Methane (CBM)

Lessons to Learn

There are a couple of useful lessons to be derived by investors looking to tap into the virtually unlimited opportunities in energy.

First, just because something is “cheap” doesn’t mean it can’t stay cheap, regardless of historical ratios -- if there has been a fundamental shift in the supply/demand equation. Which is very much the case with North American natural gas.

Secondly, geological and transport considerations make much of the energy complex a “local” market.

For example, while North America enjoys an abundance of natural gas, Europe is forced to rely on the heavy-handed Russians for the bulk of supplies. As you read this, there are companies looking to break the Russian grip by applying the same unconventional gas technologies that have so successfully built gas supplies in the U.S. -- technologies that are only just now being applied in Europe. Early investors could reap huge profits.

In short, the real opportunities are not found by simply “investing in energy” but rather by taking the time to understand the structural differences within the energy complex and cherry picking the special situations that invariably exist in a sector this large.

David Galland is the managing director of Casey Research, LLC., a private research firm providing independent analysis and investment recommendations to individual and institutional investors in North America and over 100 other countries around the globe. To learn more about the monthly Casey Energy Opportunities advisory, including a special three-month, fully guaranteed trial subscription, click here now.

Oil to Natural Gas Ratio at Historic Extreme Levels

The oil to natural gas ratio is at an extreme level not seen in at least 15 years, reports market technician Martin Goldberg. Martin is an astute market observer who I recently discovered on the Financial Sense Newshour.

With oil above $71, and natural gas below $4, you'd think that something has to give. Sure, we may be swimming at natural gas, but we also know that the cure for low prices is low prices. There's not much downside to natural gas at these prices, just a hair above its cost of production.

If you're interested in playing a pair trade, you could go long UNG, and short...isn't their an equivalent for oil? My friend and I were perusing ETF's for oil last week, and he wasn't able to find anything that wasn't double leveraged. Any suggestions?