An Explanation of the Diverging Prices of Oil and Natural Gas

Some in the business media, including the morning host and hostess on CNBC’s Squawk on the Street, admit to being confused by the seeming contradictory price movements of oil and natural gas.  This is an explanation of that divergence.

The price of natural gas can be approximated by the price of UNG, the symbol for the U.S. Natural Gas Fund, LP, a fund that attempts to mimic the price of natural gas in the U.S.  The fund’s price peaked on June 23, 2008 at $61.90 (per millions of BTUs).  By February 18,2009, its price had fallen to $17.42, a 72% decline.  Prices continued to decline and reached a low on September 4^th of $9.08 (for an 85% decline from its peak) before settling at $10.59 (an 83% decline) on September 11.

Meanwhile, the closing price per barrel of oil peaked at $145.31 on July 3, 2008, fell 76% to $34.67 by February 18, 2009, but has since risen significantly to above $70/bbl, closing at $71.31 on September 11.  Oil currently costs about four times the price of natural gas for the equivalent amount of energy.  Since both are energy resources, and in some industrial applications, are substitutes for one another, how can these prices show such divergence?  This, of course is the dilemma of the host and hostess of Squawk on the Street.

The answer lies in the nature of the markets in which the commodities trade including the deflationary forces in the U.S. domestic economy and the inflation wreaked on the U.S. dollar holder by the devaluing U.S. dollar worldwide (see The Inflation/Deflation Debate – a Reconciliation posted to this blog on September 1).

On August 27, Time discussed the domestic nature of America’s natural gas business (As Oil Explodes, Why Natural Gas Prices Stay Low).  The U.S. produces 90% of what it consumes with much of the remaining 10% being imported from Canada. Natural gas production is up because of the roaring economy and rising prices of energy two years ago (there is a time lag between new drilling and actual production and distribution).  At the same time, gas using industrial production in the U.S. is down nearly 13% both due to the recession and cooler than normal weather patterns this summer, both of which have reduced the demand for electricity (fired by natural gas power generating plants).  The falling price of natural gas is a symptom of the deflationary spiral gripping the domestic U.S. economy. Because this is one of the few commodities that is purely influenced by the domestic economy, the value of the dollar in international trade has, so far, had very little influence on natural gas prices.

The demand for oil, too, has fallen with worldwide recession.  But, the U.S. imports a majority of its needed oil, so, unlike the price of natural gas, the price of oil will be influenced by the value of the dollar vis a vis other currencies.  The following table shows the change in the value of the dollar between the February 18, 2009 low in the price of oil and September 12, 2009 relative to the U.S.’s largest trading partners (as measured from January through July, 2009) and some other significant currencies.

The top ten trading partners account for about 63% of U.S. foreign trade.  The trade weighted average change in the value of the dollar since the low in the price of oil on February 18^th is 15.2%.  If China is excluded (because they peg their currency to the dollar), the trade weighted average is 19.2%.  Add in other significant currencies, and we can be pretty well assured that the dollar has declined about 20% in value since February.  [Alternatively, the U.S. Dollar Index (USDX), a composite of six currencies (Euro 57.6%, Yen 13.6%, British Pound 11.9%, Canadian 9.1%, Swedish Krona 4.2% and Swiss Franc 3.6%) has fallen 14.5% from its peak in March through September 11^th.]  Thus, if the dollar hadn’t declined in value, then we can be pretty confident that today’s oil price would be at least 20% cheaper, or around $57/bbl instead of $71+.  In addition, there is no doubt that the price of oil has been bid up by investors/speculators who see oil as a hedge against a devaluing U.S. dollar.  How much is speculation is not known, but surely the price of oil would be significantly below $57/bbl if the speculators were not playing.

The price of natural gas, a purely domestic commodity, clearly reflects the dire demand/supply economic conditions in the deflating U.S. economy.  The price of oil, being an international commodity, reflects worldwide demand/supply (not quite as dire as in the U.S. alone) plus (when speaking of oil in terms of dollars) a significant dollar devaluation, and investor speculation of continued dollar weakness.  In the end, the U.S. consumer is paying inflated prices for oil and imported products due to deficit spending practices in Washington D.C., while the domestic economy reels from continued abhorrent job losses, an overextended consumer, and the prospect of fairly imminent confiscatory new taxes.

Robert Barone, Ph.D.