Ed Crooks Oil and gas prices: why have they diverged, and when will the divergence end?

As oil prices have raced ahead in the past few weeks, more than doubling from their low point below $33 per barrel in February, the behaviour of natural gas prices is puzzling.

Or, looked at another way, it is oil prices that are puzzling and gas prices that are easily explicable. Demand for both oil and gas is weak. Inventories for both oil and gas are high, in the US and elsewhere. In that environment, you would really expect prices to be falling.

In fact, while oil has been surging ahead, gas has been languishing. This is the chart for the US:

The red line is WTI, US crude, the blue is the Henry Hub gas price, which tracked oil pretty closely during the upswing to the peak last summer, and during the downturn through to February this year. Since then, however, the two lines have parted.

So why the divergence?

One possibility is that the oil price is being driven by speculators, or “non-commercial participants”, if you prefer the Nymex euphemism. The speculative flows in natural gas are significantly smaller than for oil, across the exchanges at least.

But it always seems unnecessary to invoke quasi-metaphysical explanations involving speculators when there is a perfectly good explanation in the physical market. The difference between oil and gas lies in what is happening to supply. Oil supply is falling fast: by 3.9m barrels per day this year, according to Sanford Bernstein, including 2.4m b/d in Opec production cuts and about 1.5m b/d in falling output from non-Opec countries including Russia, the US and Britain.

Gas supply, on the other hand, is roaring ahead, at least for the internationally-traded sector of the market, LNG. Over the next couple of years, world LNG supply is rising by about 30 per cent.

So how and when will this divergence end? Well on the one hand, it will take a long time for all that extra LNG supply to get absorbed. On the other hand, though, there is a link between gas and oil prices in Europe and Asia that may begin to reassert itself.

Look at this chart of UK gas prices against oil:

Again, the red line is oil and the blue is gas. The gas price movement tracks the US market pretty closely, reflecting the increasingly close international integration of gas markets because of the growing trade in flexible LNG cargoes that can be switched to whichever market offers the highest returns.

However, UK gas prices are also tied to continental European prices, because suppliers such as Norway have an option of selling either to Britain or to continental markets via the Netherlands and Germany. And continental prices, in turn, are linked to oil because of the price formulas used in the long-term supply contracts prevalent in those markets.

So as the oil price rises, it should put a floor under the European gas price, and eventually, with a lag of about 6 to 9 months, begin to drive prices higher. That in turn will tend to push UK prices up, and the LNG that everyone expected to be dumped onto the US market may go to European (and indeed Asian) markets instead.

Coupled with the steep decline expected in US unconventional gas production because of the slump in drilling activity, that should mean that, so long as oil does not fall sharply again, gas prices should begin to pick up by the end of the year.