The ratio between crude oil and natural gas (NYMEX) futures yesterday was 27.7. That is crude prices in $/Bbl were 27.7 X natural gas prices in $/MMbtu. The ratio today is far higher than its historical norm of 7.5X before 2007. It started to increase in 2008 and reached 54 X last year when gas prices crashed below $2/MMBtu. This year the ratio has averaged 27 X and has shown no clear trend up or down. The ratio is important because it underpins two of the key features of the shale boom to the US economy – cheap energy in the form of natural gas and higher prices for refined product and petrochemical exports. Today we attempt to discern the future direction of the ratio.
Here at RBN Energy we believe that the relationships between hydrocarbons like crude oil, natural gas and natural gas liquids (NGLs) have become far more significant in today’s energy markets than they were in the Good Old Days. Back then oil, gas and NGL markets led separate lives and the participants rarely crossed each other’s paths. Now what happens in one market has an impact on the other markets and everyone needs to understand the interrelationships. Nowhere has this been more true since the start of the shale revolution, than in the relationship between crude oil and natural gas prices. This relationship is generally measured by the price ratio between the two commodities. As reported in previous blogs (see for example “The Golden Age of Natural Gas Processors – NGLs in a 50X Crude to Gas Ratio” and Easy Come Easy Go) the crude-to-gas ratio measures the relative value of hydrocarbons in a liquid form (e.g. crude oil) and hydrocarbons in a gaseous form (e.g. natural gas). We track the crude-to-gas ratio every day on our website in the RBN Spot check graphs – you can learn more about Spot Check here. There are typically two ways to express the crude-to-gas ratio – the rule of thumb method that is simply crude price divided by natural gas price or the BTU ratio method that is gas price divided by (crude price /5.8) where 5.8 is the number of MMbtu in a barrel of crude. RBN Energy sticks to the rule of thumb method since it is more intuitive.
Conventional wisdom used to say that the crude-to-gas ratio should gravitate back to the 5.8 BTU ratio or its close approximation 6X (i.e. crude price = 6X gas price). In the 10 years from August 1997 to August 2007 the ratio averaged 7.5 X – fairly close to the ‘real” BTU ratio of 6X. Then, at the end of 2008 just after crude and natural gas prices had crashed in response to the financial crisis, the ratio began to climb. It reached around 20 X during 2009 through 2011 and then skyrocketed in 2012 as natural gas prices plunged to less than $2/MMBtu in April – leading to a crude to gas ratio of 54X. Gas prices recovered from those lows but the ratio still averaged 35 X during 2012.
That high ratio proved to be significant for two reasons in particular. First low gas prices encouraged a move by producers away from dry gas shale plays towards liquids (oil and NGL) rich basins. That is because higher liquids prices increased the rate of return for drilling in these basins. Ironically this change in drilling activity has so far not led to any decrease in natural gas production because (a) the associated gas that is produced from liquids rich wells is increasing as well; and (b) drilling in certain dry gas plays like the Northeastern part of the Pennsylvania Marcellus has become so efficient and prolific.
The second reason why the high crude-to-gas price ratio proved significant – as we learned in our Golden Age of Natural Gas Processors blog series – is that the ratio underpins strong NGL processing margins. If natural gas is less expensive and crude oil is more expensive, then NGL margins tend to be higher. That is because NGL processors transform hydrocarbons in a gaseous form (natural gas) into hydrocarbons in a liquid form (NGLs) that tend to track the price of crude oil – at least some of the time.
[Potential NGL processing returns can be estimated using another of our RBN Spot Check indicators – the Frac Spread. That is a calculation of the BTU value of NGLs versus natural gas that indicates general returns for processing NGLs (but for a more accurate analysis you need to understand the specifics of NGL plant processing economics – see our five part series on Gas Processing Economics – all referenced in Part V). We will not get into the Frac Spread in this blog – our latest update on that topic was “ Dirty Deeds Done Cheap”].
And there are other reasons to keep an eye on the crude-to-gas ratio – such as the future prospects for billion dollar plants planned for construction in Louisiana to convert natural gas to refined products. Those gas-to-liquids (GTL) plants rely on a healthy ratio between refined product prices (that generally follow crude) and natural gas (see Jumping Jack Gas). A great deal of infrastructure investment planned on the Gulf Coast also relies on low natural gas prices and higher NGL prices – including the six new olefin crackers projects underway (see Industrials Say “I’m a Believer”). A lower crude-to-gas ratio would impact the potential of these plants to compete in world markets.