Unnoticed by many, an important barrier was breached in the past two weeks -- a development which merits mention and consideration. On March 16th the ratio of spot oil to natural gas prices, on a BTU (British Thermal Unit) equivalent basis, temporarily reached a new historic high before retreating. At more than nine times the price of an equivalent amount of natural gas (measured in BTUs), oil prices by another measure once more defied gravity or reason.
Historically, the ratio, from 1997 to 2009, has averaged 1.52 times. In other words, oil -- for a variety of reasons -- has commanded a premium over an equivalent quantity of natural gas having the same energy. Oil is a more versatile form of energy. It can be used more easily (and more cheaply) refined and converted into a variety of other more useful forms, ranging from kerosene to motor gasoline to home heating oil. Oil is also easier to transport and store. And, until the fracking (hydraulic fracturing) revolution, natural gas supplies were considered to be erratic, subject to high seasonal demand. Hence the reasons for the premium users will pay for energy in petroleum form.
In the final consideration, though, both oil and natural gas are energy forms. And, both are valuable in so far they can perform work. All energy works in the same way: by creating heat, thereby causing air to expand (to drive a piston) or to convert water into steam (to drive a turbine). This is admittedly an oversimplification, but the explanation captures the essence why the BTU is the standard measure of a hydrocarbon's energy potential.
Since both oil and natural gas can be equated in BTU terms, both are ultimately substitutable. Readers may recognize a similar theme in our Chart of the Week for October 6th of last year, entitled Relatively Speaking. Relative prices provide a useful gauge to assess commodity prices. Then it was the price of oil to coal. Now it is oil to natural gas. In both instances, the price of a barrel of oil, adjusted for energy content, is unreasonably expensive compared to alternatives.
Why then has the market not arbitraged away the differential? If both are equivalent resources on some level, both should be able to perform the same work. Indeed that is true — but only in the long run. In the short-term power plants, pipelines and the corner gas station are locked into infrastructure which prohibits rapid substitution without a large investment to retrofit facilities built for oil (gasoline or diesel) to use natural gas.
Over time, if natural gas prices remain low and oil prices high, users have an incentive to make the investment. At the current BTU equivalent ratio, natural gas is a more attractive feedstock for producing gasoline and other distillates. At current spot prices, we estimate the crack spread (the gross margin earned by a plant refining oil) at 27 percent using West Texas Intermediate Crude and just 9 percent using European Brent. In either case refining margins are tight -- one of the reasons why refineries in the U.S. are idling capacity. Using natural gas improves the economics, by our estimates, by a factor of at least twenty times.
Why then have no such plants been constructed in the United States? Their absence is not for want of the necessary technology. Gas-to-liquid (GTL) chemistry (the Fischer-Tropsch method) was originally developed in the 1920s. The barriers are cost, environmental regulations (an obstacle for the construction of any new refinery) and, historically, the relative cheapness of petroleum to natural gas. In September 2011, Sasol, the South African oil company, announced plans for a feasibility study for the construction of a GTL facility in Louisiana using natural gas from Eagle Ford and other onshore fields. With luck, Washington sophists will not use the chance to endlessly ratiocinate, in the process killing yet another option for energy independence from the Middle East.
Based on daily spot prices for West Texas Intermediate Crude Oil (delivered to Cushing, OK) and Henry Hub Gulf Coast natural gas. Spot natural gas prices quoted in $s per million BTUs (British Thermal Units). Natural gas prices converted to $s per barrel of oil equivalent using the conversion factor of 5.825 Million BTUs per barrel of petroleum. Chart on the left shows the evolution in the BTU equivalent oil to gas price ratio over the past fifteen years; chart on the right illustrates the seasonality of the ratio by comparing the ratio on the 250 different business days in the years from 1997 to 2009.
(Sources: Department of Energy, Energy Information Agency; AIFS estimates.)
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