While prices for all of the energies have been on the rise for the past year, the price increases in natural gas and crude oil have not been proportionate, a departure from the norm, according to a new Merrill Lynch study.
Merrill Lynch analyst Francisco Blanch said that while WTI crude oil prices for out months have nearly doubled from $33/bbl at the end of August last year to $62/bbl this week (before Katrina), natural gas prices have not kept pace. "Natural gas prices in the Atlantic Basin have also increased over the past year, but at a much more moderate pace," he said in Merrill Lynch's Global Energy Weekly. "For instance, summer 2009 long-dated natural gas prices in the United States have increased from $4.88/MMBtu at the end of August last year to $7.29/MMBtu this week, while winter 2009 U.S. natural gas prices have surged from $5.14/MMBtu to $8.07/MMBtu this week."
He pointed out that oil-natural gas price differentials are widening throughout the curve. Blanch said that over the past ten years, WTI oil traded on average $0.86/MMBtu above U.S. natural gas on a calorific value-adjusted basis. However, on a forward looking basis, the differential has now widened substantially above the historical average, with long-dated oil now trading about $3 to $4/MMBtu above U.S. natural gas prices.
Despite the break, Blanch said natural gas prices have maintained a close link to oil on both sides of the Atlantic for more than ten years. As to whether a separation between natural gas and oil can prevail in the long-term, the analyst said he doesn't think so despite the fact that at first sight, the forward supply-demand balance for oil looks much tighter than the forward supply-demand balance for gas.
He noted that there is a substantial amount of overlap in the use of oil and gas, including the power generation sector, the residential sector, in industrial and petrochemical processes and even the transportation sector.
"While oil may have dominated the transportation sector for decades, widening oil-gas price differentials and new technological advances will likely put considerable downward pressure on demand for motor fuels," he said. "Should oil prices continue to increase at a breakneck pace relative to gas prices, a substantial amount of switching across all economic sectors could occur."
Blanch said that on a spot basis, the oil-natural gas relationship remains strong. He pointed out that in the United States, low sulphur residual fuel oil prices have continued to provide a floor to U.S. natural gas prices, while heating oil or gasoil prices provide a ceiling. "This link between oil and gas prices in the United States remains very strong through arbitrage in the power generation sector," he said. "However, refinery bottlenecks around the world have forced a separation of residual fuel oil and heating oil prices, creating a much wider price range for U.S. natural gas."
The analyst said that while natural gas and oil prices could diverge temporarily, he believes it is unlikely that a large difference in prices will persist over the long-run. "While supply may not be able to adjust over a two to three year period due to long-lead construction times, existing technologies might allow demand to complete an adjustment in the medium-term," Blanch concluded.
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