The oil markets have experienced significant price drops in the last year, mainly due to a massive supply glut. Natural gas prices, which have traditionally been coupled with oil, have followed the trend downward. Can investors count on natural gas prices to always follow crude oil? While natural gas and oil have historically moved together, the two commodities can and do diverge at times. In this article, we will examine the different factors affecting oil and natural gas prices. 

Measurement in Production

The first basic difference we will look at is the units of measurement of production: oil is measured in barrels and natural gas is measured in units of 1000 cubic feet called Mcf (the M comes from the ancient Romans letter of M, which meant 1000). The most common way to convert these two is the barrels of oil equivalent (BOE). Here, 1 BOE is equal to 6,040 cubic feet of gas, or essentially 1 BOE is equal to 6 Mcf.

Price Correlation

Our discussion now moves us towards the price correlation between oil and natural gas by following crude oil and natural gas prices. If crude oil prices move up, will natural gas prices follow? Below is a chart showing oil and natural gas price correlations between 2003 and 2014. The average correlation was 26.53%. (For more see Do Oil and Natural Gas Rise and Fall Together?)

*Chart courtesy of stockcharts.com

As you can see in the chart above, crude oil and natural gas prices sometimes moved together and sometimes moved in opposite directions. In addition, notice how there were also wide variations in how closely they correlated with each other. One explanation for the difference is that oil is a global commodity while natural gas is a more regional commodity. As such, natural gas is affected by local conditions and seasonality.

Global Impact vs. Regional Impact

Another key difference to know when investing in oil versus natural gas is the main factors that influence their prices. The price of oil is influenced by many geopolitical and economic factors. The U.S. Energy Information Agency published a report listing seven factors that affect oil markets, including changes in production in Saudi Arabia, sudden supply disruptions, changes in non-OPEC supply and changes in production levels.

In comparison, the price of natural gas is much more influenced by regional factors. This is because it is more difficult to transport natural gas abroad than it is to transport oil. In addition, the price of natural gas fluctuates strongly with temperature. High and low temperatures are the most significant determinants of natural gas demand as consumers use the gas to heat and cool their homes. Natural gas accounts for 25% of total energy use in the United States. Around 61% of homes in the United States use natural gas for heating and cooling according to the EIA. Moreover, it is among the cleanest-burning fossil fuel available. (For more see A Natural Gas Primer.)

Main Users

Another important distinction between oil and gas are their main users. Crude oil is refined into different kinds of fuel like propane, kerosene, diesel oil and gasoline, all destined for different users. Kerosene fuels jets and diesel oil is used in long-distance trucking and other kinds of transportation. Approximately two-thirds of transportation in the United States is fueled by oil. For agriculture, oil is used both directly for operating machines and indirectly for the manufacture of pesticides and fertilizers. Like kerosene and diesel, gasoline is derived from oil. According to the U.S. Energy Information Agency, 46% percent of crude oil is refined into gasoline.

Natural gas has three main users—domestic (household), industrial and power generation plants. For domestic users, natural gas is used for heating and cooling homes. Domestic users are the main consumers of natural gas in the United States. Industrial users are the second largest consumers of natural gas. Like domestic users, they also use natural gas for heating and cooling their factories. Finally, power generation plants have increasingly sought out natural gas as a source of energy. Historically, power generation plants extract heat to convert into electricity from sources including coal, natural gas and oil. Coal has typically been the predominant source for power generation plants. According to the Financial Times, a new regulation from the U.S. Environmental Protection Agency has led to an increase in the demand for natural gas. Consequently, the use of coal has declined. In April 2015, gas generated more electricity than coal in the United States for the first time in its history. 

The Bottom Line

As we can see through the comparison between oil and gas, there are many complex factors that influence the supply and demand for each of these commodities. While the price of natural gas is correlated to the price of oil, certain diverging factors, including the influence of geopolitics, the economy and seasonality, also come into effect.

 

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