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A Compelling Energy Ratio

by: Matt Blackman September 01, 2008 | about stocks: UNG    

Matt Blackman

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As the economy has cooled and the dollar rallied, crude oil prices have fallen. Lately oil appears to have formed at a minimum, a temporary support base. Whether it will fall further from here or rally remains to be seen but the fundamentals would seem to support firming energy prices. (Be sure to watch these peak oil videos.)

But whatever happens to the price of oil, the price of natural gas relative to oil is at historic lows as pointed out this week by Bespoke Investments. Given that cooler weather will begin to make itself felt in the weeks to come, the prognosis for natural gas looks promising. While oil has lost just over 20% of its value since the end of July, natural gas is down 42% from its peak.

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Figure 2 - Natural gas/crude oil ratio showing the best times to buy natural gas and sell oil (green zone bottom) and sell natural gas and buy oil (brown zone top). As we see from the chart, natural gas is cheaper in relation to oil than it’s been in sixteen years.

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Chart by GenesisFT.com

Figure 3 – The U.S. Natural Gas ETF (UNG) is one way to play natural gas. Launched April 18, 2007 the daily chart shows the more than 40% drop in price from its July high and the major support band between $34 and $36. Also note the volume capitulation spike (see green arrow in volume subgraph), a Williams Capitulation spike (see green arrow in second subgraph) and strong positive divergence between the RSI (relative strength index) and price (see green line in RSI subgraph). Taken together with the historically low natural gas/oil ratio, this represents a potentially powerful buying signal. 

According to Steve Moore in his excellent The Encylopedia of Commodity and Financial Spreads (Wiley 2006), a NG strategy to buy Nov natural gas calls and sell Oct NG calls on Aug 29 (bull call spread buying a closer to the money option while selling a further from the money options simultaneously) with a Sept 14 exit has a 100% win ratio over the last 15 years.

The natural gas/oil relationship does not guarantee that natural gas will rise tomorrow, next week or next month. Oil could drop further and so could natural gas. But if energy prices do begin firming in the near future, natural gas has the potential to significantly outperform crude oil.

Disclosure: none

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This article has 11 comments:

  •  
    Sep 01 03:59 AM
    "Given that cooler weather will begin to make itself felt in the weeks to come, the prognosis for natural gas looks promising."

    Not sure what you mean or are implying here, but cooler weather is most certainly NOT bullish for NG.

    *EXTREME* temperatures, either extreme heat or extreme cold are bullish for NG, because that results in either substantially increased air conditioning which increases usage of NG generated electrictity, or increased NG usage for heating. The *WORST* possible situation is middle of the road temperatures (slightly warm or cool) because then you have NEITHER air conditioning nor heating, and thus NG usage drops off considerably.

    I'd be careful with using this ratio at this time, because there may be some strong bearish factors for NG at play. One could be that crude oil prices continue to drop substantially if global demand is weakening, and secondly there is a ton of domestic production presently. Look at the last month or so of actual storage numbers versus estimates. Not bullish.

    I'm long some NG producers (CHK and XTO) but definitely concerned about downside at the present. Buying UNG here might be risky. 4-6 might very well be in the cards.
    Reply
  •  
    Sep 01 09:11 AM
    Your technical analysis makes sense. The previous poster noting storage is bearish, but everyone knows that already. The forecast I've heard for a cooler winter is bullish. The economy/demand is bearish. Politics are bullish (international tensions and US likely Dem win in Nov). . . Opposing arguments are both strong. Perhaps that is the reason for the volitility. And that is exactly what I'm playing. So the volume spike/selloff I bought aggressively but sold the previous spike > 40. Tomorrow looks like another drop, will add. If we get a huge drop like previous poster talked about (I've heard other energy traders warn of the early 90's), good to keep some powder dry. Opportunity to trade almost daily. But I agree the long term is bullish so that is the bias.

    Reply
  •  
    Sep 01 09:31 AM
    MDC has some excellent insights on just what might happen in a bearish energy market,

    some of us investors just buy positions for the future, and options are downright dangerous,

    I'll just sit back and wait for the next upturn , because the downturn is likely to be ugly. Even though oil prices are still high, and coming down they will mark the beginning of incredible bargains for developing long positions as nat gas stocks take a nosedive again.

    Its a market alright - and the short term mentality of so many traders in options shows how insane it gets in highly volatile trading markets. I would hope that the news-meisters would recognize that many are truly investors in energy over the long term, and that it isn't the high price of commodities that makes us all look bad - its the promotion of short term trading strategies for a quick buck that we all have to live with.

    whipsawn again,

    so much for patience.
    Reply
  •  
    Sep 01 10:13 AM
    The kicker on ratios..whether it's oil/gas or gold/silver is always the outsized future production or discoveries. On the whole though, it's just another indicator that like silver, nat gas has incredible varieties of use, and just doesn't get lots of respect. The US could well consider LNG export terminals rather than fractionation sites..and start cutting Russian gas out of Europe...why not..they're such lovely people.
    Also...the previous post is testament to poor parental upbringing. Mommy either needs to keep him in his basement bedroom without a computer or supervise him. Truly a male no sober woman would touch.
    Reply
  •  
    Sep 01 01:27 PM
    Everybody has an opinion on how bearish the ng storage numbers are right now. May I remind you that we are still below last year's level and are very unlikely to reach that level by November 1st (considered the beginning of heating season). 5-yr storage avgs although somewhat useful do not paint the full picture mainly because ng demand increases every year and supply/demand picture from 5 years ago may or may not be relevant to the present situation.
    Bob Simpson (CEO of XTO), one of the shrewdest guys in the ng business has stated several times that we will have periods of storage surplus but that over the long haul demand will outstrip supply resulting in higher ng prices. XTO has already hedged over 60% of its 2008 and 2009 production at $10.10 so either way they win you lose.
    Reply
  •  
    Sep 01 09:38 PM
    Sep 01 04:37 PMuser211108 - i read the nyt aricle you mentioned. Basically, it just lists the roadblocks people keep thowing in the way of getting the right things done.

    As I have said in other blogs, the grid needs to be beefed up and expanded, and also provide for solar and wind hook-up. And I grossly stated that high power transmission lines are probably within 25-50 miles of any future installation.

    Take a look at where all the hydro installations are (Grand Coulee Dam in the middle of nowhere is the equivalent of 8 (eight) 1000 MWe nuc plants. No look at the rest of the hydro locations west/midwest/southeast... etc. As for nucs; we have over 100 1000 MWe plants scattered around the US - few states without - most state are less than 200 mi in one direction or another. Then there is the coal - everywhere??

    So, the grid problem is just a bunch of roadblocks (policy/politics/regul... - we have the technology and wherewithall to improve it and expand it immediately. Report abuse
    nakedjaybird
    Sep 01 09:20 PMYou know, in the NYTimes article, a FERC member member is quoted saying we need an "INTERSTATE TRANSMISSION SUPERHIGHWAY SYSTEM" - he is so right.

    And where they should run that grid is alongside/between/abov... the US Interstate hiway system that exists. And then, put the electrified ferries on steel-wheeled rails in the same space. Then we simply take the cargo off the diesel (biodiesel hybrid) trucks and ferry it electrically powered by solar and wind - that's a good role for solar and wind.

    Centainly takes the wind out of the sails of the contras that continually talk about balancing the grid.

    This idea solves two if not three problems at the same time. Since the Gov't steamrolled for the interstate highway system, let them steamroll for electrifying it. Simple. The right of way is there. Who's going to argure?. Yes, I know, someone will.

    And what's the distance between interstate hiways? Do they go thru wind mill and solar land, and do they eventually move right into cities, and go thru where all the people are. DUH??

    I hope someone in FERC reads this.

    Help out, guys. I'm like solarPV on a native hut, with a microwave, color TV, cell phone, but connected to no one.


    Report abuse
    nakedjaybird
    Sep 01 09:27 PMOh yes, and wireless internet!

    But I'm as helpless as all the steers running around me and that just reminds me of Washington DC every time I look at them and feed them. And what do I get in return - about the same stuff - let me help you city folks, it's hot, wet, sort of like putty, and smells like shit. If it looks like, smells like, feels like, it probably is.........yup!

    Happy Memorial Day to all the Vets and all those enjoying the freedom they have provided in the US and worldwide - regardless of the naysayers.
    Reply
  •  
    Sep 02 04:55 AM
    "Everybody has an opinion on how bearish the ng storage numbers are right now. May I remind you that we are still below last year's level and are very unlikely to reach that level by November 1st (considered the beginning of heating season). 5-yr storage avgs although somewhat useful do not paint the full picture mainly because ng demand increases every year and supply/demand picture from 5 years ago may or may not be relevant to the present situation. "

    **********************...

    You are right about where we sit presently relative to the 5-year average, but I think you are way off about it being unlikely to reach there by Nov 1st. At the rate we are going with injections, the 5-year average might be left in the dust in the coming weeks unless producers curtail production.

    As far as supply/demand, off the top of my head, I think 2008 supply growth is running around 8-10% annual growth, while demand growth is around 1-2%. I think that is why just in the past day or so you are seeing commercials with Aubrey McClendon pushing CNG for transportation. Right now, it sure looks like an imbalance to me, and new sources of demand need to come on in short order to absorb this increase in supplies. I am still bullish on NG over the next 3-10 years, but the next 6-12 months could be rough unless something changes quick in the supply/demand picture. I hope many of the producers get smart here and start to curtail production. Either that, or some of the smaller, weaker players need to get killed off and that might happen for those companies that are unhedged if NG goes to 4.
    Reply
  •  
    Sep 02 07:12 AM
    Oil prices are going below $100.00 and NG prices will follow.

    Go to:

    www.stopoilspeculation.../

    and you will see what I am talking about.

    Also, when the Democratic Party wins the White House you can bet that tax breaks for alternative energy projects will be renewed and NG prices will go down because of excess supply from new discoveries.

    OBAMA / BIDEN 08
    Reply
  •  
    Sep 02 03:19 PM
    Matt, thanks for the article. Something to keep in mind though:

    Could the downward trend in your first graph imply that since 2003 oil is seeing more upwards pressure on the cost of production than natural gas?

    I think some of us sense that the "low hanging fruit" is gone with respect to the world's major oilfields.

    That it pays (and pays well!) to scrape up two tonnes of dirt in the tar sands just to squeeze out one bbl should tell you something.

    Unless the cost of producing natural gas also rises to meet the historical norm, this might be a long-term downward trend and you might not see a bounce to the extent you are expecting.
    Reply
  •  
    Sep 06 02:39 AM
    JJASON. I didn't know U.S or any of it's political members have ANY control over energy prices whatsoever. How come oil is at $100 and was $140. Hmmm...no one in U.S was able to do anything about it.
    The OIL price is controled by OPEC nations not U.S or democratic party bud. Alternativies take 30-40yrs to develop, cost much more to develop and no one is taking initiative to do it. It's a buzz word. Oil floor pirce is $100 as that was major resistance last year. OPEC aka arabs will now allow oil to get under $100 since they have double digit inflation in their countries due to U.S tresuries, so their hedge is oil price. Cantrell mexican oil field is crashing hard, which NO one is paying attention. Reasearch that too.
    Reply
  •  
    Sep 06 09:48 AM
    Trading options could add a layer of complexity to the trade that some might abhor.

    There is an attractive seasonality in the natural gas/crude oil price relationship, but the ratio is not a very reliable indicator. Using energy-equivalent prices paints a more accurate picture (An explanation of this can be found in the Hard Assets Investor article, "Spreading Oil and Natural Gas" at www.hardassetsinvestor...).

    The article illustrates a short-term seasonal futures spread ,with good historic reliability, that capitalizes upon this seasonality.

    A simple 1:1 version of the spread (long natural gas/short crude oil), lodged on the first business day after the Labor Day holiday, would have cranked out a 35% return on margin by Friday's close.
    Reply
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