Why Is Oil's Price So High Compared to Natural Gas?

If, as an investor, motorist, or reader, you're perplexed and surprised by the continuing anomaly in the oil/natural gas relationship, joing the club.

The background/lowdown: Oil historically trades at about 8 times the price of natural gas. Currently it is trading at 20.4 times natural gas.

Oil (West Texas Intermediate) Wednesday closed up $2.64 to $81.95 per barrel, while natural gas closed up about 1 cent to $4.00 per million British thermal units (MMBtu).

One reason for the continuing large oil/natural gas ratio is the recent social/political change in the Middle East -- the Arab world's reforms -- which have increased concerns about contagion to Saudi Arabia, and/or perhaps Iran, two major oil exporting nations. That's pushed West Texas Intermediate oil up more than 10%, and Brent oil up more than 15%. Another is the civil war in Libya, which has taken about 1 million barrels per day (bpd) of crude oil off the market.

However, some of the price discrepancy also reflects the depressed condition of U.S. natural gas prices, due to sluggish demand and a large increase in supply stemming from new, innovative drilling techniques, including hydraulic fracturing, also known as "fracking," that have substantially increased the natural gas supply.

During the leverage-happy 2003-2008 period, natural gas prices soared to $13.69 per MMBtu.

Meanwhile, oil, the world's most vital commodity, for several reasons, has resisted sustained price moves lower: whether its oil-as-an-asset-play, or the threat of inflation, or a weakening dollar, or OPEC production cuts, or the prospect of rising demand in emerging markets, or Arab world reform, oil has (so far) found a way to defy gravity and remain at prices above $70, despite a tepid U.S. economic recovery.

To be sure, natural gas demand has increased in 2011 in the U.S. -- a warmer-than-normal summer across much of the eastern and southern U.S. has boost demand for natural gas from electric utilities. Further, demand will probably continue to improve in 2012, assuming U.S. GDP growth does not fall below 2 percent in 2011, but that demand rise probably will not been enough to boost natural gas permanently over $6 per MMBtu.

Energy/Economic Analysis: The calculation here argues that oil's price is not likely to retreat much, perhaps declining to about $70-75 per barrel, if hedge funds and investment funds continue to pull "hot money' out of the commodity on concern about sub-trend (sub-adequate) global GDP growth, and that a natural gas price rise will account for much of whatever gap closing occurs.

Of course, a counter-argument would forward that perhaps we've entered a new era in the oil/natural gas relationship -- one in which the ratio is perpetually high.

Still, history argues against that thesis: something has got to give in the oil/natural gas relationship.