Oil and Natural Gas Reserves

Monday, February 05, 2007

Will Oil and Natural Gas Prices Remain Coupled Going Forward?

Natural gas and oil prices have historically been correlated in the US, demonstrated by some very interesting graphs at the EIA that show in the US that natural gas prices and oil prices have followed a similar trend since 1994 (pdf warning)[http://www.eia.doe.gov/oiaf/aeo/conf/pdf/petak.pdf]. The EIA in May of 06 has concluded that the "Oil and gas prices are likely to stay coupled as supply/demand balances remain tight for both fuels," but hedges this forecast with the statement: "however, significant price volatility is likely."

As further background to this issue, citing the oil and natural gas price correlation most energy firms have traditionally used a "6 to 1" ratio in their corversation between oil and natural gas in their reserves statement. For example, the disclosure in Exxon Mobile's 2005 10-K of its treatment of natural gas to reserves is typcial of the industry:

"The volumes of natural gas were converted to oil-equivalent barrels based on a conversion factor of six thousand cubic feet per barrel." (XOM 2005 10-K)

Such a conversion rests on the correlation between oil and natural gas prices on a BTU basis.

The question that stems most directly from this discussion is: will the correlation between oil and natural gas prices continue in the future unaltered? In order to answer this question, a more fundamental question should be asked: what, fundamentally, are the drivers of natural gas prices and oil prices in the US and how are they similiar/different?

It is argued here that the drivers of natural gas prices and oil prices are not linked in the US directly. Natural gas prices in the US (note that the author is not as familiar with the gas industry in Europe and Asia) -- are significantly more volitile than oil prices -- and are driven by the rigid structure of the natural gas industry. Rapid declines in natural gas prices after a warm winter are caused by storage tariffs requiring witdrawals in inventory, causing storage gas to be emptied into a market that is already saturated. On the other hand, rapid increases in natural gas prices are caused by a lack of capacity and storage to fully supply a market under high demand conditions.

In the past the extremes in the natural gas industry were not as pronounced -- as the US has added a significant amount of natural gas fired power plants without a corresponding increase in storage since 2001 (natural gas storage capactiy has actually declined slightly), and further, weather temperatures are expected to increase in volitility going forward. In other words, with a lower storage as a percentage of industry production and demand, and higher weather volitility, the drivers of natural gas and oil prices are set to become more pronouced in future years in the US. So the differences in price drivers are such: in the oil industry the US recieves a world price for oil while the natural gas prices are determined by domestic considerations that are becoming more extreme.

Going forward, the introduction of more LNG will likely -- in the author's opinion (which is different from many industry observers) mean even more volitility in natural gas pricing. LNG will face similar issues as existing natural gas storage in that it is expensive to store, and if existing LNG terminal storage holders are full after a peak season, then they will likely sell (dump) their gas into a market along with traditional natural gas storage. Meaning price collapses will likely be even more pronouced. Further, there will be more variability/uncertainty in natural gas prices as based on the highly uncertain future of LNG supply.

The upshot of this discussion is for the investor to pay more attention to the ratio of oil to gas in the energy company's reserves statement. To the extent that the firm holds more natural gas and less oil as a percentage of reserves, (and has not hedged future years' production) it is likely that the earnings will be more volitile as natural gas prices rise and collapse dramatically. Also, one can conclude that less earnings volitility should give a slight nod to energy firms with a higher percentage holdings of oil verses natural gas.


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