Natural Gas and Oil Spreads: What’s Up with Energy Prices?

In 1974, as oil reached new highs, Richard Nixon declared that the United States would be energy independent by 1980.

He barked his claim as part of a State of the Union Address, outlining his goal he said, “At the end of this decade, in the year 1980, the United States will not be dependent on any other country for the energy we need to provide our jobs, to heat our homes, and to keep our transportation moving.”

Of course, we all know what happened in the years to follow. Energy independence has been the campaign staple since the 1970s oil crisis. For all the wild claims and far off projections, the United States has never been truly energy independent. But recent trends suggest we may not be far off – a divergence in energy prices in the US and abroad only confirms that the future may bring an energy independent United States.

Oil Prices: Who Pays?

The United States became a net exporter of gasoline, heating oil, and diesel fuel in 2011 for the first time since 1949. This appears to be remarkable progress, until you consider the factors that make the United States a prime oil exporter.

Refiners have a unique business model – turning oil into new substances for fuel, plastics, and other products. Products coming out from refiners in the US mainland are priced based on import prices (Brent oil), even though refiners source local oil at the West Texas Intermediate price, which is substantially lower than Brent crude imports.

Refining product in the United States with WTI oil for export to foreign lands with Brent pricing is incredibly profitable. In effect, US gasoline consumers lose some of the geographical edge for US gas production. We pay higher prices for gasoline, while international consumers pay lower prices as US oil supplies allow for geographic arbitrage around the world.

World Prices are Economically Irrational

A confluence of factors makes the energy markets more confusing than ever. Brent crude continues to sell for a 15% premium to American West Texas Intermediate gasoline. But that’s just one single relationship. What about other sources of energy?

The market has to question the net effect of an American natural gas fracking boom, a relatively new development. The chart below demonstrates a growing disconnect between natural gas and West Texas Intermediate crude oil:

Energy is simple science. How much work can you do with one unit of natural gas compared to one unit of oil? In a perfect world, these two energy sources would be arbitraged with little volatility. When oil becomes inexpensive relative to natural gas, consumers would use oil. When natural gas becomes inexpensive relative to oil, consumers would opt for natural gas.

Of course, rigidity exists. No one purchases two cars in natural gas and gasoline variants to arbitrage prices. No one installs two heating systems for their homes – electric and natural gas – to alternate between the two when one makes more economic sense than the other. Power plants built to generate electricity from coal can’t make an immediate overnight switch to natural gas should natural gas prove to be less expensive. Energy, despite being a commodity in pure form, still requires massive infrastructural investments for arbitrage.

Pairs Trade?

Darwin outlined a pairs trade between two companies in the cell phone space. So how about a pairs trade for energy?

Eventually, one would expect natural gas and oil prices to revert to the mean ratio of roughly 15:1. At 55:1, natural gas would have to triple in value, or oil would need fall by 66% to have a reversion to the mean.

Adjusted for BTUs, the United States sits on 170-340 billion barrels of oil equivalent in the form of natural gas. For comparison, the United States consumes just under 7 billion barrels each year – roughly one-fourth of global oil production. Every natural gas firm wants to bring this to ground with new fracking technologies. Except, at the current price, most natural gas firms are barely profitable, or unprofitable.

So what’s the trade here? Short oil and long natural gas? It makes sense, at least economically. One could go long a major, highly-levered natural gas stock like Chesapeake (CHK), and sell short a high-cost oil sands firm like Suncor Energy (SU). If the spread narrows by a combination of rising natural gas prices and falling oil prices, traders win on both trades – CHK’s intrinsic value increases, SU’s should decline.

You could further leverage the position (while limiting losses) with long-term call options on Chesapeake, and puts on Suncor.

One thing is certain: the disconnect cannot exist forever. In the long-run, everything reverts to the mean, even if large infrastructural changes are necessary to implement necessary arbitrage. Whoever gets this trade right will, without question, laugh all the way to the bank.

Is it time to wager on an energy independent America?

What do you think the future will bring for American-produced natural gas?

Have you noticed natural gas-powered taxis, buses, etc. on local roads?

Disclosure: The author holds no positions in the above companies.