Until the natural gas market was deregulated in the 1970s and early 1980s, U.S. gas prices were subject to federal controls. Deregulation resulted in a freer market, and competitive forces were largely allowed to determine prices. In fact, recent studies suggest that oil prices drove changes in gas prices, but are not influenced by them. Essentially, an increase in oil prices leads consumers to substitute petroleum products for natural gas in the industrial and power sectors, which increases gas demand, and thereby prices.

Figure 1 shows the monthly average price of natural gas (HH) versus gasoil and fuel oil (U.S. Gulf prices). Seasonality is apparent in the HH price series, with prices often peaking in the winter months. Prior to 1999, HH tracked fuel oil prices more closely than gasoil, but as the gas market has tightened, the dynamics have changed and volatility has increased, with prices fluctuating between gasoil and fuel oil prices. The figure indicates a buildup of HH prices that started in 1999, peaked in January 2001, and then dropped in the winter of 2002-03. A colder than normal winter in 2001-02 caused a sharp price increase then, with the U.S. entering the season with its gas storage below full capacity. A similar situation occurred in the winter of 2003-04. Prices also increased dramatically to a new record towards the end of 2005, due to hurricane-related disruptions.

For the past year and a half, HH prices moved closer to fuel oil prices, pressured downward by an unusually warm winter. But for the past few months, HH prices have remained depressed, while both gasoil and fuel oil have skyrocketed. This brings into question whether gas prices are now decoupled from oil prices and whether this is permanent.

Weakening prices are always the consequence of supply outgrowing demand (or demand contracting more than supply). As storage levels are a good indicator of the balance between gas supply and demand, a look at U.S. storage levels is useful to understand why HH prices have remained weak since 2006. Because gas consumption is seasonal but output is not, storage is built in the summer for use in the winter, leading to seasonal patterns in storage levels.

Due to the warm winter in 2006-07, consumption dropped by 2.3 percent in 2006 versus 2005, and storage rose to record levels as a result. Natural gas consumption over the first eight months of this year rose by 5 percent over the same period last year, while output increased by 2 percent. However, an export increase of 4.4 percent over the same period was outpaced by an 11.7 percent imports increase, due partly to relatively attractive U.S. prices, contributing to an increase in storage levels. Overall, the storage level in August 2007 was some 1.6 percent higher than the already high level of a year ago, and was far above historical seasonal averages. As a result, gas prices continued to remain depressed.

The recent weakness in the HH price is a result of the above normal level of stocks, caused largely by a warm winter and an imports increase. A lack of output disruptions, such as the 2005 hurricanes, put further downward pressure on prices. In essence, gas prices are now decoupled from oil prices due to deviations from normal conditions. Oil and gas prices continue to have a stable long-term relationship, despite periods when a large deviation from normal conditions may have temporarily decoupled them. Such exogenous factors include weather, seasonality, inventories, and shut-in production.

However, historical data indicates that deviations in natural gas prices from their long-term relationship with oil prices induced changes in demand, and this tended to realign gas and oil prices. This is likely to happen again as the market moves forward.

Since we are interested in the long-term relationship between oil and natural gas, issues related to seasonality and the temporary decoupling between the two fuels may be largely set aside to focus on annual data. Natural gas prices tend to move between gasoil and fuel oil prices, so it may be more accurate to project the price of natural gas based on these product prices, rather than conventional rules of thumb relating natural gas and crude oil prices. Figure 2 shows the annual prices of HH, gasoil, and fuel oil. We have added the average price of gasoil and fuel oil, depicted by the blue line.

Figure 3 shows the price ratio of natural gas (HH) to the average of gasoil and fuel oil prices in the U.S. market. The price ratio has generally trended upwards, before declining over the last few years. It has been found that a polynomial time trend of the order of two can be used to estimate this ratio (as indicated by the dotted trend line). In essence, the time trend is included to capture both the trend and cyclical patterns in the data series. The price relationship seems complex, and is slowly evolving rather than constant. The resulting regression equation for the estimation of HH prices is given as:

HH = (0.33 + 0.0965×t – 0.004×t2)×

(Average of Fuel Oil and Gasoil/5.8)

where t is a time trend. Fuel oil and gasoil in the U.S. are priced in dollars per barrel and natural gas prices (HH) are in dollars per MMBtu equivalent. The results are compared in Figure 4 using two common metrics for assessing the relationship between oil and natural gas: the 10-to-1 rule and the 6-to-1 rule. The first assumes that HH gas (per million Btu) will be priced at 10 percent of that of West Texas Intermediate. The 6-to-1 rule assumes that HH gas will equal one-sixth of the WTI price.

The mean absolute errors for the three sets of estimates are summarized below.

Overall, it is clear that estimates based on dual product prices (gasoil and fuel oil) are superior (that is, have the lowest error) to those using the two simple rules (10-to-1 and 6-to-1), and may be appropriate to assume as the long-run relationship between oil and gas prices under normal conditions. However, the 6-to-1 (or 10-to-1) rule performs better under a bullish (or bearish) price environment.

Short-run deviations from the estimated long-run relationship could be explained by exogenous factors such as storage levels (deviations from historical averages), weather (deviations from norms), and the quantity of production shut in due to hurricanes. It is worth mentioning that HH prices over the past decade had been hovering within the ranges of estimates between the 6-to-1 and 10-to-1 rules. In fact, 2007 estimates using the 10-to-1 rule are spot on, which supports the fact that oil and gas prices are not decoupling.

Price Outlook for Oil and Gas

The global oil market is seeing the repercussions of its lack of investment in both the upstream and downstream sectors in the 1990s, when oil prices were low and refining margins were poor. The current situation is markedly different from the previous price shocks, which were impelled by the sudden contraction of oil supply. Price increases in recent years have been product-led and demand-driven on the back of tighter refining capacity.

Apart from fundamental factors, many in the oil market believe that the crude price has been significantly elevated by the fear premium. The fear premium is prompted by geopolitical uncertainties in various exporting countries and a lack of flexibility due to low excess capacity. There are also allegations that speculative hedge funds inflate prices above what the fundamentals would indicate.

Oil prices continued to rise despite the fact that OPEC raised its output by 500,000 bpd on November 1, 2007. The market was worried about a supply crunch at the approach of the winter. Major crude markets have in recent months reverted to backwardation, after having been in sustained contango for months, with a more bullish sentiment. Oil demand growth is expected to slow at the current high prices, and in response to an expected slower global economic growth next year. But we feel that on average, prices will move slightly higher in 2008 than this year, as OPEC continues to restrict its output. WTI crude prices are expected to rise from this year’s estimated $71.15 per barrel to an average of $72.65 per barrel in 2008.

We project HH prices will average around $8.40 per MMBtu under normal conditions in 2008, using the dual-product price-based method. But the overhang of inventories this year suggests that HH prices could be slightly weaker, even if the seasonal weather pattern were normal. If this winter is as warm as the last, then HH prices may average lower, at around $7.30 per MMBtu (using the 10-to-1 rule). The 6-to-1 rule would be suitable for projecting gas prices under a cold winter or when there are output disruptions, and is expected to average around $12.10 per MMBtu. With the inventory overhang, it seems that only a prolonged colder than normal winter could help to bring prices up to this level.

Conclusion

Oil and gas prices continue to show a stable long-term relationship despite periods when exogenous factors, such as an abnormally warm winter, may produce the appearance that the two prices have decoupled. Short-term natural gas prices could be affected by oil prices, weather, seasonality, natural gas storage levels, and disruptions in natural gas production. The dual-product price-based method is suitable for forecasting gas prices under normal conditions (such as a normal winter), while the 10-to-1 rule (or 6-to-1 rule) would perform better when bearish (or bullish) factors dominate, such as a warmer (or colder) winter.

Dr. Jit Yang Lim is a senior consultant at FACTS Global Energy, a Honolulu-based energy consulting firm.