Why Natural Gas and Oil Won't Diverge for Long

Crude oil prices are once again breaking the $62-a-barrel level for WTI (West Texas Intermediate, the traded benchmark in New York), while Brent (the most-used global figure set daily in London) is north of $68.

Yet natural gas (according to Henry Hub, the U.S. standard), while drifting up slightly yesterday, has been moving in a very different direction.

As of close in trade Monday, WTI was up 2.3% for week and 8.9% for the month. Brent rose 2% for the week and 9.2% for the month.

Henry Hub, on the other hand, was up 3.6% for the month but down 3.7% for the week.

Both energy sources have faced prospects of excess supply, prompting once again concerns that extra volume will suppress prices.

However, as I have noted before, crude practitioners have learned to live with the excess extractable oil. Merely because it is in the ground does not mean it needs to be pumped right into the market.

And this will be key for us determining oil's moves this year...

How We'll Know Where Oil Prices Are Heading Next

Excess extractable volume will weigh on the price, but less significantly so if traders setting the futures contracts are convinced it will not be dumped.

Remember, this is all about perception. And the perceived cost of the next available barrel continues to drive where contracts are pegged.

To compensate for pricing risk, those cutting futures contracts will peg prices to the highest expected barrel cost while prices are increasing and the least expected barrel cost when prices are in decline. As oil approaches balance between supply and demand (and between availability and expectations), perceptions should narrow.

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That is a good development for the predictability of oil prices, although geopolitical matters will continue to throw an element of uncertainty into the mix.

An entire gamut from Venezuelan financial collapse through saber rattling in the South China Sea, Korean tensions, Libyan and Nigerian civil insurrections, and a once again increasingly dangerous Persian Gulf will guarantee that the unknown will have something to say about how the market approaches pricing.

Natural gas remains a very different situation. There, declining U.S. supplies in storage combined with record-setting cold and "blizzard cycle" conditions should have resulted in a spike in gas prices.

It certainly did so in the case of with thermal coal. The VanEck Vectors Coal ETF (NYSE Arca: KOL), for example, increased 6.2% over the past week and a very strong 14.8% for the month through close Monday.

But that's not the case with natural gas. In what was to some a quite unexpected result, natural gas produced a subdued monthly rise but a protracted decline during the very period in which tradition would prescribe that gas prices would spike.

Currently, the price of around $2.85 per 1,000 cubic feet (or million Btus) is well below where most analysts (myself included) had expected gas to be at this point.

Without question, there will be a significant drawdown from stockpiles this week following the weather blast only now showing signs of abating on the East Coast. That will result in a rise in price.

Yet that increase does not appear to be sustainable as more seasonal weather hits.

Unlike previous periods, higher natural gas prices are no longer entirely dependent on abnormally cold winter weather. As we have discussed several times, there are additional gas usages coming in to play: exported liquified natural gas (LNG); replacement of coal in the generation of electricity; substitution for oil products as feeder stock for petrochemicals; rising industrial use; and the expansion of LNG, compressed natural gas (CNG), and hybrid vehicles.

Nonetheless, the expected improvement in prices has been slow to materialize.

And there are a few reasons for this...

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Why Natural Gas Is Lagging - but Not for Long

The first reason has been the nature of natural gas production. Most of the expenses in drilling a gas well are front-loaded. Some 80% or more of the cost is laid out before anything comes up hole. The volume flow is the life line for return on investment and extends for years irrespective of market conditions.

Second, the United States has significant (and relatively easily extractable) unconventional (shale and tight) reserves. Any decline in overall market supply will be quickly replaced by new extraction.

Third, capping a gas well is more problematic than capping an oil well. That means an operator facing a likely reduction in prices because of excess supply already in the market will nonetheless continue pumping.

Finally, the real reason prices have not increased is the long side of the futures contracts (i.e., those betting that the price will rise) has disappeared. In the absence of any forward-moving pressure, prices will stagnate or decline.

In fact, the most probable move this week is one pushing prices lower as shorts (i.e., those contracts making money if the price retreats) once again take over. There will be a sizable decline in gas in storage, but that will only dampen the move down.

We are left then with a very unusual dynamic. My estimates of where crude oil will be at the end of first-quarter 2018 (WTI $61-$62; Brent $63-$65) have already been met or exceeded. Natural gas, on the other hand, continues to languish.

However, as I outlined in my 2018 Energy Forecast, I still anticipate Henry Hub to reach $3.50 by the end of summer. That's up more than 20% from current levels.

As short bets fade out of view and production winds down, natural gas prices will have nowhere to go but up.

I'll be back soon with an update on natural gas - and how we can position ourselves for profits.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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