June 12th, 2009

The Linkage From Oil to Natural Gas to UNG

A number of readers write in with questions or stock recommendations. Natural Gas has become a recurring theme in many of these communications so I figured it was time to dig up some research. One of the most informative sources was Wikinvest (located, by the way, by searching for “oil prices and natural gas prices” on Microsoft’s new search engine, Bing.com). Some facts I learned at the site include:

  • per unit of energy its combustion produces 30% less carbon dioxide than oil, and about 45% less carbon dioxide than coal
  • Natural gas is more abundant [than oil]: at constant levels of production, the worlds proven supply of natural gas will last 65 years, higher than oil’s 41 years.
  • Like oil, however, most supply rests outside US borders (96.7% for natural gas); United States holds only 3% of the worlds proven reserves of natural gas, compared to 28% for for Russia and 40% for the Middle East
  • key drivers of the end-user price of natural gas are two-fold. (1) The raw fuel costs account for about 60% of final costs, while (2) the transmission and distribution costs account for the remaining 40%
  • it is challenging both to transport and to store [natural gas], limiting the short-term flexibility of supply in response to demand shocks.
  • predominant method of transportation in North America is via natural gas pipelines
  • LNG (liquified natural gas, an increasingly popular method of transport) requires major investment in both deep-water, sheltered ports to harbor LNG tankers and in liquefaction and gasification plants on both ends of the transport route. As of December 2008, the U.S. had 8 LNG terminals but plans to nearly double capacity over the next 3-5 years
  • Storage [of gas inventories in low usage months for supply in winter] also offers an opportunity to reduce the cost of natural gas
  • A barrel of oil contains approximately 5.8 million BTU’s of energy, natural gas (priced in terms of 1.0 million BTU’s) should trade at one sixth the price of oil …. In theory, when the oil/gas ratio is above 6, there is an arbitrage opportunity available from purchasing gas [storing it] and selling it when prices revert to the energy equivalence value
  • Natural gas prices historically are correlated with oil prices
  • US fulfills more than 65% of its oil needs from imports, triple that of natural gas, changing the supply/demand fundamentals between the two sources of energy.
  • since excess supply in North America can’t be cheaply shipped to other countries, falling domestic demand has translated into rapidly falling prices.
  • Over the next year, there are enough liquefied natural gas plants set to come online to expand global natural gas demand by 30%
  • From September 2008 to March 2009, the number of natural gas drilling rigs operating in the U.S. fell from 1,606 to 884, because of the contraction in gas prices
  • Natural gas demand observably fluctuates on a seasonal basis, falling in summer months and rising in winter months
  • fears over repeatedly bad hurricane seasons have led to higher prices because of their track record of causing supply disruptions
  • the previously informal association of countries in the GECF- Gas Exporting Countries Forum transitioned to a more formal status by adopting a formal charter and opening offices in Doha, Qatar

All interesting but as an individual investor how do I play these facts? I built a date chain linking oil prices, natural gas prices and the price of UNG, the Natural Gas ETF and most convenient way for investors to monitor and invest in natural gas (click here for spreadsheet).

There have been some interesting divergences in the price of UNG relative to the price of Natural Gas and between Natural Gas and the current price of oil. A history of the link between the price for a barrel of oil and UNG compared to the actual price of UNG since it was first traded in April, 2007 is:

The Financial Time just included an interesting story about growth in the activity in UNG is causing some interesting unanticipated problems entitled “The problem with commodity ETFs” by Izabella Kaminska. According to the story, the huge open position is causing difficulty as the expiration of futures options approach and:

Given this uncertainty we would rather play it from the safe side and reduce the NatGas exposure for the next four days. Furthermore, this will be the first time that the UNG rolls such a position (double the size as a month ago) which means that the managers of the UNG have no practical experience in the rolling of such a large position and of its potential market impact….Causation or correlation with UNG aside, one thing is sure – some very peculiar things have been going on with the price of natural gas since the fund began to inflate. People are beginning to wonder why.

So while the theoretical price of UNG is around 27.50 given the current price of oil, the actual price is between 14 and 15. The large exposure might explain why UNG hasn’t moved up. It’s all very complex and I hope I’ve helped those interested in playing this commodity.

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