Investors Shouldn't Gorge on Natural Gas

By LIAM DENNING Junk food appeals to our primal instincts: It is a cheap way of loading up on calories. Right now, natural gas is the energy world's junk food. Burning a barrel of oil releases about 5.8 million British thermal units of energy. In theory, therefore, the price of oil, measured in barrels, should be roughly six times that of natural gas, which is priced per million BTUs. Since 1994, the average has been 8.6 times. Today, with spot natural gas costing about $4 per million BTUs, it is almost 18 times. Investors with faith in mean-reverting markets smell an opportunity to sell oil and buy natural gas. Yet the ratio itself has become increasingly irrelevant as the underlying fuels have decoupled in terms of use since the 1970s. Transportation accounts for 70% of U.S. oil consumption now, while most natural gas is used for heating, power generation and industrial processes. That largely rules out switching between them in response to short-term price signals. Oil trades globally, whereas natural gas, mostly shipped in pipelines, is characterized by regional markets. This matters because, as Francisco Blanch, head of global commodity research at Banc of America-Merrill Lynch, says, U.S. natural gas "is the mirror image of oil." While resource nationalism in foreign countries limited investment in response to high oil prices, high natural-gas prices earlier this decade sparked a drilling boom at home. Compounding this, the U.S. can now import as much as 19% of its needs as liquefied natural gas shipped in from further afield. The global recession has squeezed the spread in natural-gas prices between the U.S. and traditionally more expensive overseas markets, increasing the chances of LNG cargoes targeting America. LNG production facilities have low variable operating costs, meaning natural-gas prices would have to collapse even further before they were mothballed. Amazingly, though, U.S. natural-gas output actually rose in the first quarter, while demand fell 5%. This is despite the number of rigs operating falling by more than half in the past year, suggesting production per rig has been increasing. Exploration and production companies also have shown skill at navigating the downturn. The sector's investment case is predicated on growth, and capital expenditure has outpaced operating cash flow for several years. E&P companies believe, with some cause, time is on their side, given political trends favoring lower-carbon-emitting fossil fuels like natural gas. The recent stock-market rally has allowed several overleveraged companies to recapitalize. Futures markets also lend support. The December 2010 contract commands $7.25 per million BTUs, implying an oil/natural-gas ratio of 10.8 times. This reflects hopes of natural-gas demand reviving with the economy next year and allows drillers to lock in higher prices. This week, EnCana, North America's largest producer, announced it had sold 35% of its expected 2010 output at an average price of $6.21 per million BTUs. Then there is the high oil/natural-gas ratio. Many natural-gas producers also produce oil. Credit Suisse analyst Jonathan Wolff points out that the extra cash flow provided by the rebound in crude prices offers further relief for some E&P companies. So natural-gas producers live to drill another day -- meaning pressure on prices is unlikely to lift. For now, exuberant markets allow producers to keep selling output forward, as well as raising equity to repair balance sheets and keep spending. Come fall, if already high natural-gas inventories have risen further, such forgiveness will be in short supply. The oil/natural-gas ratio may well have come in, but more likely because of faltering crude prices. Write to Liam Denning at liam.denning@wsj.com