The Decoupling of Oil and Gas Prices

By Peter McKenzie-Brown

Energy forms are not created equal. Gasoline and diesel are great fuels for transportation, and at the moment there are few viable alternatives. Coal, on the other hand, is just dandy for generating electricity and smelting metals. Natural gas is terrific for space heating, powering electricity-generating turbines and manufacturing fertilizer and petrochemicals. Because of their different applications and their different energy densities, hydrocarbons have different relative prices. And until recently, they were priced in a band which reflected their relative values.

That band is now falling apart. Perhaps this is a sign of things to come - but not before the market experiences what commodity traders call a "short squeeze". The chart shows the price of oil compared to that of natural gas in North America. Until recently, natural gas prices traded in a fairly close ratio to the price of oil. Depending on the state of the industry, the ratios formed a band which ranged from 10:1 to 6:1. Here’s a practical example of how helpful those ratios used to be.

Petroleum industry analysts make their estimates of the future price of petroleum stocks based on their future cash flow – that is, the amount of cash they will have available from production. If they wanted to estimate the future net worth of an oil producer, for example, they would make a knowledgeable assumption about the price of oil in the coming year and an estimate of the company’s total oil production for the coming year. A bit of fifth grade arithmetic then enabled them to estimate the value of that company’s shares. To illustrate, let’s begin with four assumptions:

• First, the company under review will produce a million barrels of oil in the coming year. • Second, the average price of a barrel of oil will be $25. • Third the company’s cost of oil production will be $10 per barrel. • Fourth, the company has 15 million shares outstanding.

Given these assumptions, the company’s cash flow for the coming year would be $15 million, and cash flow per share would be one dollar. To get a good idea of the likely price of the stock in a year's time, we would then ask ourselves whether we thought oil stocks would be in a bull market then or a bear. If we were bearish, we would estimate the price at year end by multiplying that dollar of cash flow by three. If we were bullish, we would multiply it by five. So shares of the company in question would have an implied value of $3-$5. What if the company’s production consisted of natural gas rather than oil?

You can see on the chart that until recently, natural gas prices tracked the price of oil fairly closely – so much so that immutable ratios about the relative value of oil and gas seemed to exist. When gas prices were strong, a gas producer would only have to produce six times as much gas as oil (6,000 cubic feet of gas equals 1 barrel of oil) to be on equal terms with an oil producer. For example, to generate the same cash flow as the little oil producer I just described, in good times a gas producer would only have to produce 6 billion cubic feet of gas a year. If natural gas prices were relatively low, the company would have to produce perhaps ten times as much gas – 10 billion cubic feet per year – to have the same share price as our oil producer.

Eternal Verities: For many years these ratios seemed to be eternal verities for oil and gas producers. Then, last year, the verities fell apart. Oil and gas decoupled. In 2006 gas averaged less than $6, while oil was $65. The 10:1 ratio had been breached. And the situation today? Natural gas on the NYMEX is $7, while oil is $96. That’s a ratio of more than 13 to one. The once seemingly immutable ratios have collapsed, and the gaps are widening. One outcome is that the shares of natural gas producers – especially Canadian gas producers – are in the toilet. The following chart of Rider Resources illustrates the disasters that befell investors in Canadian gas stocks during 2007. What does all this mean? On a continent and in a world facing hydrocarbon-related energy and environmental problems, the cleanest and most efficient form of hydrocarbon energy has become the ugly stepsister compared to its less secure and much dirtier competitor, crude oil. This is not a happy state of affairs – especially since the North American gas industry is in decline.

 Forecasters now commonly suggest that Western Canada's conventional gas production has peaked and will continue to decline. In the United States, reserves peaked years ago. The reasons are complex, but the practical reality is that the economics of gas production stink, especially in Canada. The $7 futures contract for gas on the NYMEX isn’t reality here. In Western Canada, our producers get $5-6 per thousand cubic feet for their gas, while the cost of finding and developing the stuff is in the $7-$9 range. Because of the strong Canadian dollar, a less attractive fiscal regime in Alberta, the lack of storage facilities and for other reasons, the Western Canada sedimentary basin is now the most expensive place in North America to find natural gas, and the least profitable in which to develop and produce it. This is the reversal of yet another verity. Until recently, Western Canada’s natural gas hunting grounds were among the most profitable and prolific in North America.

Greenhouse Gases: In a world nearing the crude oil peak, you would expect something like this to happen. The simple, cold logic of economics 101 implies that tightening oil supplies would send price signals which would identify the problem, spur crude oil exploration and make previously marginal resources profitable. The irony, though, is that in North America these events are taking place to a large extent at the expense of natural gas – an energy resource that can be used to fuel vehicles, generate electricity and fire industrial boilers. As we approach Hubbert’s peak, we are neglecting development of one of the few viable alternatives available, and one which, compared to all other hydrocarbons, contributes less per energy unit of the greenhouse gases that appear to be warming our planet. In a world where oil and gas prices have decoupled in this way, it may seem to make economic sense to bail out of gas producers like Rider Resources: Put your money into companies developing pollution-intensive resources like the oil sands. If you subscribe to peak oil theory, and if gas is relatively plentiful while oil isn’t, then the decoupling I described makes sense and is a long-term trend. It also means – and this is a serious environmental problem – that a world desperate for energy will focus investment on oil and coal (environmentally unfriendly) rather than gas (environmentally friendly.)

Medium Term: I believe this is probable over the medium term, at least, because of the growing importance of liquefied natural gas (shipped by boat from plentiful overseas reserves) in world trade. LNG will help keep North American gas prices relatively depressed, since it can be landed in the US for as little as $4-5 per thousand cubic feet. If that trade continues to grow, then the decoupling will continue. However, nothing moves in a straight line, and there is a strong case to be made for rapid upward adjustments in gas prices. Perhaps the ratio of gas and oil prices will soon revert back toward the mean - either because oil prices drop or (in my view more likely) gas prices climb. As the above chart of the natural gas exchange-traded fund (ETF) shows, US natural gas stocks may have just about hit bottom.

From an investment point of view, if natural gas prices are about to rise and you can anticipate when they will begin to make this move. You could make a lot of money by buying companies like Rider Resources (I personally do not own this stock) rather than avoiding them. Evidence that such a situation may be upon us can be found in this chart, which shows net positions in natural gas contracts. The net long positions held by the commercials and small speculators are so extreme that they suggest that a "short squeeze" could be in the offing.

 A short squeeze occurs when short sellers start to feel pressure from a rising stock or commodity - natural gas, in this case. Their losses increase as prices move higher. This "squeeze" places pressure on those holding short positions by forcing them to buy back their bearish positions in order to limit their losses. Short squeezes often result in dramatic price gains over relatively small periods of time due to this spike of buying pressure. If that's what's happening here, the commercial buyers (who tend to win over the long term because they better understand the market) and the small speculators seem ready to cream the large speculators. Stay tuned: This could be more fun than the Grand Ole Opry.

Why are Canadians the World's Energy Pigs?

By Peter McKenzie-Brown
Canada is rich, big and cold, and we share two borders with the United States. Those factors explain why we are the world’s energy pigs, but they do not justify it. Only the United States comes close to our per capita annual energy consumption - more than 8,300 kilograms of crude oil equivalent for every Canuck. If that crude oil equivalent were bottled water exported from France, at 2.2 litres per day it would take you ten years to drink it all. However, you would be well hydrated throughout.

Lots of American energy consumption comes from nuclear-fuelled electricity, while Canada’s nuclear industry is proportionately much smaller. That said, 63% of Canada's electricity is hydroelectric - third after Norway (97% hydro) and Iceland (100% hydro and geothermal).

Rich: Unless you are living in Caracas, where subsidized gasoline sells for three cents per litre, you have noticed that gasoline prices are skyrocketing. This concerns us all. Indeed, three quarters of Canadians worry that they will be personally affected by a gasoline shortage in the next five years, but their actions do not seem to match their anguish. Last year, for example, 43 per cent of Canadians reported increasing their consumption of gasoline during the previous three years, compared to 21 per cent who reported lowering it.

Yet during that three-year period, prices nearly doubled. This partly reflects the economic good times of recent years. Many Canadians have seen their personal wealth (think house prices) grow greatly. For many, this has made gasoline price increases – a small part of most household budgets – seem less significant than they would in a recession, say. The relative insignificance of fuel pricing today is one of the main reasons we are less likely to change our driving habits than we did during the last great run-up in gasoline prices - between 1975 and 1980. We have become addicted to gasoline, and that addiction is growing. The fact that we aren’t responsive to higher prices is contributing to the world's energy problems.

Big and cold: Why do Canadians use a lot of energy? For one thing, we live in a large country with a cold climate. We need a lot of gas and heating oil for our homes, to power our economy and to drive long distances.

Winter affects us in not-so-obvious ways. In the winter cold, the fuel efficiency of our vehicles drops. Also, of course, most of us would rather drive than stand at the bus stop in a blizzard, so we avoid the cold by getting in the car. Our driving habits and driving conditions are often fuel-inefficient. Many of us drive big vehicles, including SUVs and trucks, and we own more of them than in the past; the two-car family is the norm. Some of us drive at high speeds. Many of us carry extra weight (golf clubs) in the trunk. And city roads are more likely to be gridlocked during rush hour. All of this wastes fuel.

In addition, we have an increasing dependency on cars. Our vehicles are more fuel-efficient than in the past, but suburban development has created greater distances between home and the places where we work and play. Walking and cycling to work are less likely to be serious options for us than in the past. Suburbs often don’t have easy access to public transit, and the situation is worse in rural areas. So we drive. Nation-wide, only about one adult Canadian in four walks, cycles or takes public transit to work or school. Sixty-one percent of us drive our cars every day.

America’s neighbour: Most Canadians believe we do some things better than the Americans. In particular, we think we have created a more civil society. Illogically, from that starting point we seem to believe we also do better in the matter of energy consumption and management. However, it just ain’t so.

Among the nations of the world, Canada has the greatest appetite for hydrocarbon energy - you know, the types of energy that are getting scarcer and cannot be renewed. Oh, yeah: global warming. In response to the energy crises of the 1970s, Western Europe kept its per capita consumption in check. (See small chart.) So did Japan and Korea, after they became fully developed economies.

For their part, the North Americans were quite a different story. Like the Eveready bunny, our demands for ever more energy have kept going and going and going. In the United States, Americans have shown wizening aversion to high energy taxes. That isn't surprising.

Let’s not forget how much the American economy's 20th century growth was fuelled by its vast energy wealth. Today, of course, energy imports have instead become a major drain on US wealth. Also, there are big differences in distribution of wealth between the US and Canada.

In Canada aboriginal reserves house serious social problems, but there are few pockets of deep poverty in our inner cities. On average, in this country everyone who needs a vehicle can afford one.

That is less true in the US. America's relative wealth gives it greater flexibility in energy. Rather counter-intuitively, the rich can cut their gas consumption more easily than the poor when prices rise. Imagine the schmuck with an old beater – his only car. Compare him to the rich guy who owns a truck, an SUV, a Ferrari and a Toyota sedan. When prices go up, the rich guy drives his Toyota more, saving fuel. The poor guy still drives his un-tuned rattletrap. It’s easier for the rich (read Americans) to save fuel than Canadians. That's reality.

Whatever the reason, successive US governments refused to impose high taxes on fuel in the way most other OECD countries did.Compare the growth rate for hydrocarbon consumption in Canada (chart just above) to that in America (chart 'way above). Population growth was slightly higher in Canada than in the US.

The Canadian disadvantage: Neither did Canada, arguing that increasing energy costs would put the country's industries (many of them energy-intensive, resource extraction operations) at a disadvantage compared to those of its biggest trading partner and competitor. The result? The world’s energy pig got bigger and consumed, in relative terms, more and more non-renewable energy. And it did so as the world made striking advances in energy-efficient technologies, processes and procedures.

Canadian costs and taxes are higher than in the US, but still low relative to Europe. Gasoline in Norway, the Netherlands, Britain and France is more than $6 per US gallon - about twice what we pay in Canada. By comparison, our gasoline prices are cheap. It's Canada's good luck to have the oilsands. They will be supplying the world's energy markets a hundred years from now.

We have other world-class resources - natural resources, of course, but also people and social systems. As a society, we have done many things right. Our schools are rated among the best in the world. We have relatively little crime and a social safety net for the poor and dispossessed. We welcome refugees, and we take pride in our social, cultural and linguistic diversity. We have universal health care and gun control.

Much of our energy consumption goes into mining, forestry and other resource extraction industries. Also, it takes a lot of energy to manufacture light oil from the oilsands and to produce refined products for export to the States. Even so, the disproportionately increasing demand for energy in this country is nothing to be proud of. It is a national disgrace.