Are natural gas and oil prices correlated?

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Many financial and economic articles I’ve read report on energy prices as well as commodities in general. But even if you follow the trends in retail gas and retail power prices, which are strongly correlated, it seems that wholesale natural gas and crude oil prices are not moving together much of the time when they should trend together.

There are many reasons why natural gas and oil prices should trend together. Oil and gas demand are both driven by trends in energy usage for the same purposes including space heating, power generation, manufacturing, etc. When energy demand increases or decreases, it generally changes for all fuels.

And participants in the energy market are trading both types of energy, sometimes for the same strategic purposes, including, but not limited to: hedging by consumers and suppliers, market speculation, inflation or foreign currency plays related to commodity price trends and more. In fact, you and I can personally invest in commodity mutual funds that may have a “bucket” of commodity that are purchased or sold together, thereby increasing the strength of any correlation.

Until about five years ago, there was a strong correlation between gas and oil. In fact, some businesses have historically been able to switch fuels based on economics and take advantage of brief market anomalies. From early 2007 to mid-2008, oil and gas prices have more than doubled, and a year later, were both lower than they had started as part of the global commodity bubble and subsequent collapse.

Enter shale gas. While oil prices recovered along with the world economy and global commodity prices, natural gas prices stayed low as U.S. domestic gas production boomed. While oil imports are falling, they still represent 40% of U.S. consumption (the lowest figure since 1991) while natural gas imports represent only 5% of U.S. consumption. Unlike oil prices, natural gas prices are not subject to the volatility of the world market, the whims of OPEC and the geopolitics of the Middle East. Oil prices have recovered to roughly two-thirds of the 2008 peak while natural gas is less than one-third of its peak. And before shale, the U.S. was constructing LNG import terminals to bring in more supply. Due to international natural gas prices exceeding $10 and U.S. prices near $4 per MMBtu, the U.S. is now constructing export facilities. Natural gas is helping to make the U.S. more energy independent, although there is a lively debate regarding shale gas drilling.

For electricity consumers, the correlation between power and gas has strengthened while the link to oil has weakened. In the 1970’s, both natural gas and oil were used to generate approximately 20-25% of domestic electricity. Since then, natural gas share has increased to over 40%, while oil’s share has plummeted to less than 5%.

Moving forward, natural gas and oil prices will generally go their own way as natural gas and power prices benefit from prolific domestic supply. Occasionally gas will move with oil due to certain news events, but shale will be the key driver of natural gas. The long-term relationship is less certain. Shale oil production is behind natural gas, but is growing rapidly. And the eventual export of LNG starting in 2016 may increase the correlation of U.S. natural gas prices to international prices. In addition, growth in U.S. industrial demand and natural gas vehicles could increase demand to take advantage of the domestic natural gas discount. It will be a question of how much domestic production is allowed to be exported and how much demand grows. Recent rallies in long-term gas prices after proposed LNG export terminals received key regulatory approvals could be a warning sign. Natural gas could eventually become an international market like oil. But for now, enjoy the discounts of the domestic gas and power markets and be thankful that your bill does not move in the same way as the price for gasoline at the pump.

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