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Goldman: Natgas-Oil Disconnect Will Only Last So Long

The surge in U.S. unconventional gas production from shale plays has led to a disconnect between natural gas prices and the oil complex, which can persist in the near-to-medium term but is not sustainable in the long run, said analysts in a new Goldman Sachs report on commodities.

The team of analysts led by Samantha Dart said the natural gas discount to oil is so wide because oil products can substitute for gas in the generation sector when gas is expensive, but gas cannot substitute for oil in the transportation sector when oil is expensive. On Friday July natural gas futures added 10.5 cents to close at $3.949 while August crude futures dropped $1.07 to finish at $69.16/bbl, good for an oil/gas ratio of 17.5.

"Recently, there has been no need for gas-to-oil fuel substitution to guarantee sufficient natural gas supplies for the winter," Dart wrote. "This has been a drastic shift from what took place during most of this decade. Specifically, annual changes in U.S. natural gas production started to decline towards the second half of the 1990s and turned negative in the beginning of this decade. As a result, it became increasingly difficult to store enough natural gas during the summer to guarantee supplies for heating purposes during the winter."

As a result U.S. natural gas started to price in line with the oil complex, promoting frequent fuel substitution away from gas and into residual fuel oil, and sometimes even distillate fuel, for power generation, the Goldman report noted.

"The surge observed in U.S. natural gas production in the past two years has eliminated the need for gas-to-oil substitution in the U.S. to guarantee sufficient natural gas supplies during the winter," Dart wrote. "As a result, the oil/gas ratio is near historical highs. We believe this ratio can increase further this summer as natural gas prices remain under pressure to curtail supply (through persistent drilling cuts) and incentivize demand (through coal-to gas fuel substitution). In contrast, we expect oil prices to continue to rise through year-end (and thereafter) as fundamentals improve. Given that this marked difference in fundamentals between oil and gas is not fully embedded in the forward market through the end of 2009, we are opening a trading recommendation to go long the oil/gas ratio."

Dart said both crude and natural gas markets have been over-supplied, which drove prices of both fuels almost 80% down from their peak in July 2008 to their bottom earlier this year. However, she noted that oil prices have since more than doubled while natural gas prices have risen only 24%. As a result the oil/gas ratio moved above 19 earlier this month, while the 2000-2008 average ratio was approximately 8. She predicted that the oil/gas ratio could reach record-high levels near 22 later this summer, well above the current forward market.

With gas obviously not following oil, Dart said she believes gas it is now trading against Appalachian coal. "Given the current excess supply in gas markets, instead of gas being substituted by oil products to leave more natural gas in inventories, now increased demand for natural gas is required to eliminate the excess supply in the system," she wrote.

Dart said this goal can be accomplished by coal-to-gas fuel substitution in the generation sector, such as what happened in the 2001/2002 winter. Specifically, she said that a 35 cents/MMBtu to 40 cents/MMBtu minimum coal-to-gas price differential is necessary to motivate enough fuel switching to keep U.S. natural gas inventory levels from breaching storage capacity this summer.

The report noted that substitution capacity between oil and gas is limited in the near term. While some switching away from oil and into natural gas can be done in Asia, the analysts said it is unlikely to move the liquefied natural gas (LNG) market enough to support U.S. natural gas prices, particularly as U.S. natural gas prices represent a floor for spot LNG prices this year.

"In the long run, however, we believe that such a wide discount of natural gas relative to oil is not sustainable," Dart wrote. "Either via an increased use of natural gas vehicles (NGV), electric cars or the mass scaling up of gas-to-liquids (GTL) technology, we believe that this wide arbitrage opportunity will eventually close as the oil market will find ways to demand more of the cheaper fuel."

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