What do relative energy values say about future oil and natural gas prices?

Oil and natural gas prices in the US have historically tracked each other on the basis of relative energy values (oil has around 6 times the energy value of gas). Up until around 2008 any difference in relative values has been rapidly arbitraged away over a period of a few years or so. However, since 2008 the difference in relative values blew out to enormous proportions. While the collapse in oil prices since mid-2014 has brought energy markets more into line there is more to do which could have implications for both crude (WTI) and natural gas prices.

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Between 1990 and 2008 the average energy value of natural gas versus crude was 72% (the grey line in the chart). Now although there was volatility around this level the market arbitraged away the difference in price over a period of a few years or so. Since 2008 things changed. The ratio of gas to WTI over the past six years has averaged 29%.

While the fracking boom in the US impacted both gas and oil production the impact on the oil market was hidden by large unplanned problems in other key producers (think Iraq, Libya, Iran etc). Large manufacturing companies in the US (e.g. chemical producers and the like) saw low gas prices and thinking that high oil prices were here to stay invested accordingly, in the case of chemical companies placing large investments in ethylene capacity. To an extent this is what the market should be doing, arbitraging away the differences in price (as a side note the question for some is whether they have now over invested?).

So does the sharp drop in the oil price mean that the market has finished its work? Well even at current oil prices the ratio between gas and WTI is still only 33%. Remember the average pre-2008 was 72%. To get back to this ratio clearly WTI has to fall, natural gas prices have to rise or a combination of the two. At current market prices if oil shouldered all the responsibility WTI prices would need to fall to $22 per barrel!

Related article: Oil prices: History does not repeat itself, but it often rhymes

Dairy price rebound looks unsustainable on weak Chinese interest

Dairy prices have soared by a quarter since the start of the year with wholesale milk powder prices approaching $2,900 per tonne on GlobalDairyTrade. Despite the recent increase, dairy prices are still down by over 40% versus year earlier levels.

To recap wholesale milk powder prices doubled between July 2012 and March 2013 due to drought in New Zealand and frenetic buying by China as they built up strategic stocks. Record high prices encouraged farmers to invest in bigger herds and nutritional supplements resulting in surplus supplies as China retreated from the market. The cure for high prices is high prices.

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Related article: Dairy prices plunge 38% as Chinese demand dries up

The surge in prices since the start of the year reflects reports of declining pasture conditions in New Zealand, the top milk producing country. However, with inventories still plentiful and little evidence that China will return in a big way as it works through high stockpiles this latest surge seems unlikely to gain any traction.

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Rig count induced rally in oil prices likely to be short lived

The latest US rig count data, released on Friday showed rigs in use down 90 to 1543. The total rig count is down 20% over the past eight weeks to its lowest levels since June 2010. Oil prices jumped sharply on the news with Brent up more than 8% at one point to over $53 per barrel. The drop in the rig count shouldn’t have been such a surprise, with rigs tending to follow oil prices with a four month lag. Based on the chart below the rig count could fall by another 30% from current levels.

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Source: ZeroHedge

The CEO of Carbo Ceramics put this in some perspective.

“We expect the drilling rig declines to be very quick, and those rig percentage drops to be toward the high end of what all of you estimate, the 30% to 50%, and that other people have put out in literature.”

“…we came out of holiday season, started very slow. And there’s literally, I don’t know what the right word to you is — concern/panic by E&P operators, service companies. This is pretty historic. … But people are scrambling, and they’re making decisions every day. And we’re seeing people actually — a frac crew show up at rig site ready to frac, and all of a sudden the clients stop it. So don’t underestimate how fast the industry is slowing down.”

“I think, from our experience, the industry always underestimates the down cycle and overestimates the recovery cycle. In other words, it gets worse than expected, and is slower to recover.”

Ultimately the question for the oil market is what impact this will have on production. Last week the EIA produced this chart forecasting that US onshore oil output would be broadly stable despite a near term drop in rigs. One of the assumptions they based this on was that rigs would drop by 24% between January and October 2015 before beginning to rebound thereafter. The previous chart suggests the fall could be higher, but not significantly so. And remember, there is more to it than just the rig count. Drilling efficiency, the rate of decline from existing wells and the amount of time between the start of drilling and the completion of a well can all affect oil output.

Even accounting for the likely impact on US oil production, it is a drop in the ocean compared with industry forecasts of a 1 million b/d over-supply in 1H2015. Given the unprecedented speculative sell off over recent months there was a risk that the market focuses too narrowly on one piece of news and being vulnerable to a rebound.

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Related article: Oil prices: History does not repeat itself, but it often rhymes

Related article: Oil market suffers “unprecedented speculative sell-off”