Here’s Why Oil And Natural Gas Prices Are Diverging (USO)

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October 27, 2017 7:29am NYSE:USO

Tubes running in the direction of the setting sun. Pipeline transportation is most common way of transporting goods such as Oil, natural gas or water on long distances.

From Kent Moors: Almost from the start of modern trading of futures contracts in the early 1980s, there’s been an expected trading connection between crude oil and natural gas.


Of course, the parallel between the two had tacitly existed much earlier.

It was usually calculated in “BTU equivalences,” meaning that the convenience of moving from gas to oil (or vice versa) was summarized by how much heat energy each could generate (measured in British Thermal Units – BTUs).

That both energy resources happened to be drilled in essentially the same way and, even more so, tended to be found together only accentuated the equivalence.

Given these factors, market prices often changed in lockstep.

But over the past two decades, the traditional assumptions underlying this connection have been predicated on a factor that’s quickly going away…

Which is why I now see oil and gas prices diverging.

Here’s who the “winner” will be…

Oil and Gas Prices are Already Diverging

When the BTU relationship between oil and gas was initially advanced, thermal heat had been the main ingredient. While both natural gas and low-sulfur heating oil remain staple ways to heat a home in the winter (a central BTU-related matter), these days the environment is quite different.

And with these changes, the coupling of crude oil and natural gas prices has been eroded.

To be sure, there is still a connection. But it is far weaker.

Take the most recent pricing, for example.

WTI (West Texas Intermediate, the benchmark crude oil rate used in New York and set in Cushing, OK) and Henry Hub (the major natural gas pipeline confluence in Louisiana where natural gas prices are set) have had similar price changes over the past month through close of trade yesterday – +1.14 percent and +1.7 percent, respectively.

Yet for the most recent week, Henry Hub is up 3.5 percent while WTI is up only 0.8 percent.

Natural gas has experienced a more sluggish recovery than crude oil has. But as we move back into a cooler winter cycle for much of the country, that is likely to reverse.

In fact, despite some significant concerns over surpluses in storage, many analysts (myself included) see gas prices moving up quicker than oil for at least the next three quarters. The main reason involves how different the end-use markets are for each resource, compared to those from only a few years ago.

And this is the reason oil and gas are likely to see a separation in prices moving forward. While both are experiencing increasing demand, natural gas has seen a greater expansion of consumption options…

Differences in Use are Leading to Differences in Pricing

Both oil and gas will experience a rise in exports.

U.S. oil exports are now at or above 2 million barrels a day, from zero only a few years ago.

That’s because Congress removed a prohibition from exporting crude that had lasted over four decades.

Established on national security grounds following the oil embargo of 1973-74, the ban had prevented all but very limited exports until recently.

Even here, however, the foreign sales favor gas more than oil.

The U.S. is poised to represent between 6 percent and 8 percent of the global liquefied natural gas (LNG) market by 2020. Once again, this is an increase from nothing.

The LNG export flow comprises a significant new outlet for domestic production, and a much greater stimulus for siphoning off excess production than the rise in exports on the oil side.

Moreover, the transition from coal to natural gas for the generation of electricity has been underway for some time.

In fact, the usage of gas in the power industry has been increasing faster than I originally expected. In the next few years another wave of that transition will happen, as at least 17 percent of the aging generating capacity nationwide (much of it coal-powered) is replaced.

Virtually all of the new capacity will be natural gas, renewables, or a co-fueled combination of the two.

Some estimates point to a substantial decline in excess gas supplies in the U.S. as a result of this single factor.

In other areas, such as feeder stock for petrochemical production, industrial applications, and even transportation fuel, the rise in natural gas use will come at the expense of crude oil.

All of this bodes well for diversifying natural gas demand beyond the traditional heating markets.

On the other hand, there is no likelihood of any pressure on the supply side. There is considerable excess extractable volume available. The ease with which the gas can be extracted also provides ample restraint against rapidly rising prices.

This is also not another indication that the “death of oil” is upon us.

Prices will begin to react to different factors, but oil will continue to comprise a major element in the energy mix. Oil prices will reflect what is occurring globally.

Natural gas, on the other hand, will have its price determined domestically. Both will still have local demand to fill.

In other words, this is not a winner-take-all situation. Rather, we’re moving into a more nuanced pricing dynamic.

That will be opening up some very good investment opportunities on both gas and oil companies.

The United States Oil Fund LP ETF (USO) fell $0.02 (-0.19%) in premarket trading Friday. Year-to-date, USO has declined -9.81%, versus a 15.41% rise in the benchmark S&P 500 index during the same period.

USO currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #54 of 129 ETFs in the Commodity ETFs category.


This article is brought to you courtesy of OilPrice.com.


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