The parting of oil prices from natural gas prices – examining their declining relation

As I have referred in a previous post about the publication made on Forbs regarding the crude oil prices to natural gas price ratio in which there is correlation between the two commodities’ prices and therefore one could use this ratio to make some prediction about on of the prices.

I won’t further elaborate on this ratio; I think I have made my point about it in that previous post.  I would like to draw your attention to another claim that there is a strong positive correlation between crude oil price and natural gas price.

For that end, I have comprised two series: crude oil price (future short term) vs. natural gas price(future short term).

In the following graph you can see the trend of both of these commodities series, with one manipulation I have made on it: I have converted the USD/barrel of the crude oil price to USD/ MMBTU (using a 5.8 MMBTU to barrel converter rate, based on EIA reasoning). By doing so, both of these series are at equal grounds.  The graph shows a close relationship between the two series, in which until the beginning of 2006, they were in similar price levels.  This is also shown in the correlation between the two series in which from 1994-2008 the correlation between the percent changes of the two series is 0.306. Not great but pretty good.

After 2006, the two price series parted ways but still show some consistency in price fluctuations. In 2006 there started a decline in the correlation as for the next two years (2006-2007) the correlation declined to 0.2. From 2009 the graph shows that the two series have parted ways in their trend as crude oil price jumped to higher levels while natural gas prices plummeted, this is also corroborated with the correlation between the two series falling for the years 2009-2010 to 0.13.

Graph Crude oil and Natural Gas Prices  in USD-MMBTU

*Monthly average prices; Source: EIA website

What does it all mean? For one thing, if you had any further doubts about whether of not the correlation between crude oil price and natural gas spot price could be used to predict one of these series, then I hope that this graph will put the kibosh on this issue.

In order to explain this graph, we will need to look beyond these numbers and do some research. I would speculate that this shift in the trend of crude oil price is due to our further dependency in crude oil, in which the consumption and its growth are not met with the current declining stocks. On the other hand, natural gas doesn’t suffer from this problem mainly as the natural gas stocks don’t deplete as fast as crude oil does, despite the increase in the world’s energy consumption. For this last claim I can refer you to the steady decline in natural gas consumption along with the high levels of storage in natural gas (in fact, on November 5th, 2010 the EIA recorded the highest levels of the past 17 years, since it started to reporting these figures, at a 3,840 billion cubic feet level). All a while, the EIA expects that the consumption in crude oil will rise as they have reported recently.

Is it an air tight proof? Not really, but it could give you a good sense of where things are headed in the long run, but of course to have a more reliable take we will need to further research this issue.