As year-over-year weather comparisons become more favorable and surplus natural gas currently available shrinks on increased demand, the price ratio between oil and gas should “at least” approach Btu parity of 6:1 and possibly get narrower over the next six months, Raymond James analysts said in a new report. With front-end oil futures near $60/bbl, “that means the fair value for gas is about $10/Mcf, not $7.36,” which is the current price of front-month gas futures.
Raymond James’ view runs contrary to other analysts’ forecasts, including Bentek Energy LLC and the Energy Information Administration (EIA). Denver-based Bentek said last fall that with new drilling in the Rockies, prices could fall as low as $3/MMBtu later this year (see Daily GPI, Dec. 10, 2004). And the EIA earlier this month forecast prices to remain in a range of $6.50-7/Mcf through the summer and end the year around $7.50 (see Daily GPI, June 13).
In its report, Raymond James analysts noted that “under a normalized weather scenario, we would expect the price of gas to move much closer to that of heating oil by early 2006. Assuming that crude stays near current levels, this would imply gas at above $10/Mcf. Accordingly, if and when gas approaches parity with heating oil, the oil/gas price ratio should approach the 5.5:1 level.”
Over time, Raymond James analysts continue to believe that the oil/gas price ratio should ultimately converge to around 6:1. “Given the incremental costs of burning oil-based fuels and the relative scarcity of gas during the winter season, one could even argue that the ratio should be closer 5.5:1 over the longer term. U.S. natural gas prices are depressed due to mild U.S. weather over the past year.”
The analysts noted that a “substantial” amount of gas demand was lost relative to normal weather. “The demand destruction created enough oversupply in the gas market to depress gas prices relative to oil. Given that abnormal weather has driven gas prices lower, we do not believe that the current price ratios are permanent.”
Oil/gas price ratios have been narrowing for 15 years, the analysts wrote. The 1990s, they said, began with a ratio near an “astonishing 20:1 but ended with a much more reasonable 8:1.” The ratio has been stable in recent years, but generally has been below 8:1 and sometimes as low as 4:1.
“Obviously, over the past 15 years, both oil and gas prices have increased massively. However, the key point is that gas prices have increased much more in percentage terms,” the analysts said. For example, they noted that gas prices in June 2005 were, on average, five times higher than in June 1990. On the other hand, oil prices were only about three times higher. As a result, the price ratio compressed and is now closer to Btu parity.
“Though the price ratio has varied over time, it has displayed a distinct underlying downward trend. The reason for this trend is simple: This country is running out of (natural) gas. To put a less dramatic spin on it, the U.S. gas supply bubble — which had been present throughout the 1980s and early 1990s — has now been completely worked off. We estimate that domestic gas production peaked in 2001 or 2002, and has been declining ever since, by about 2% to 4% per year. Despite the 40%+ increase in drilling activity over the past two years, there has been almost no supply response, except merely to moderate the rates of decline.”
Raymond James analysts said that similar to the 1970s, when domestic oil production continued to fall, regardless of how many rigs were drilling, “we think we are nearing (if not at) a similar crossroads in the U.S. gas supply picture.”
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