Courtesy of Futuresource.com, I have included three charts. One illustrates the monthly chart of the nearest (May) WTI futures contract. Another chart shows the nearest Natural Gas futures monthly chart. The third chart illustrates the Gas-futures price divided by Oil-futures price.
One way to illustrate the relative value of Natural Gas is by dividing WTI-futures by the Gas-future contract, the so called WTI/NG-ratio. It is easy to note that the relative value of Natural Gas is currently ‘low’ in comparison of Oil, since NG is clearly underperforming.
The WTI/NG-ratio, based on its nearest futures prices, shot through the roof in one year from 9 to a level of more than 21. In other words: The Gas price is now approximately 2.3 times cheaper than 12 months ago. In 2008, the low and the high of this ratio, was from 9.5 to almost 14. At that time 14 was an ‘extreme’ high level, until Oil broke out above 14 and outperformed Gas dramatically. The current level just above 20 might offer an excellent trading opportunity: Buying Gas-futures contracts and selling WTI-contracts.
Differing contract specifications
It is important to note that Gas and Oil have different contract specifications. Investors should be aware that WTI is priced in dollars per barrel (bbl), while natural gas is denominated in dollars per million British thermal units (mmBTU). One way to rationalize prices is to reduce crude’s value to its energy equivalence. Assuming that one barrel of crude (on average) supplies 5.8 mmBTU, WTI can be divided by 5.8, giving its thermal energy value.
Let’s take the current futures prices of April 16, 2010 as an example: NYMEX WTI-future trades at $82.91 per barrel. The contract’s energy-equivalent price, can be easily calculated $82.91/5.8: $14.295 per mmBTU. Meanwhile, the NG May futures gas contract trades at $4.057 per mmBTU. Thus, from this perspective, natural gas is selling for 28.4% the price of oil (($4.057/$14.295)*100%).
Back in March 2009, the percentage which gas was traded against oil could be roughly calculated as follows: (($5.200/$8.966*100%)= 57.97%, assuming WTI was traded at $52 and NG was traded at $5.200. Stated in energy equivalence, nowadays Natural Gas is relatively twice as cheap as Oil: 28.4% versus 57.97% one year ago.
In recent trading, at the futures market it is said that traders [being short NG] were buying contracts to take profit. Gas-futures prices were pressured by moderate spring temperatures and a surge of supply from onshore gas fields. Some traders sited that coal-to-gas switching and nuclear power outages [in the United States] were also providing some support for gas prices. Declining gas prices have made the fuel inexpensive relative to coal (or Oil), prompting power companies to use gas in facilities that can use either fuel.
Gas and Oil can also be seen as substitutes. Also, maintenance at nuclear power plants has sparked greater gas demand to make up for the lost power generation. This type of energy plants typically refuel in the spring and autumn.
At the other end, robust gas output and moderate temperatures in the US are likely to put pressure on gas prices. Producers have continued to increase drilling activity in onshore shale-rock formations despite lower gas prices, and mild spring weather is expected to restrain demand for natural gas for heating even further.
At the current Gas price level, it is likely that gas producers will reduce output and exploration. Gas companies such as EOG Resources and SandRidge Energy stated recently that they will cut production if prices stay around $4 per mmBTU.
In other words, watch the level $4 per mmBTU! As long as NG is traded around or above this level, investors might initiate a long position in Gas (and even take a short position in Oil). However, if for whatever reason the $4 per mmBTU-level breaks significantly and Gas performs even weaker against Oil, a relatively small loss has to be taken. At the current level, the risk might be small, while the reward might turn out to be large.