By: Niels C. Jensen, CIO Absolute Return Partners
There are enough incidents ‘in the pipeline’ for natural gas (NG) prices to prove unusually volatile over the next several years. In a July research paper on oil I concluded that oil prices are likely to trade in a relatively narrow range going of around $50-80 per barrel. The opposite applies as far as natural gas prices are concerned.
Natural gas prices are, unlike oil prices, not global in nature. Prior to the financial crisis most gas prices traded in a relatively narrow range; however, around 2010, as the global economy began to recover from the great recession, natural gas prices began to diverge quite significantly. The U.S. proxy (Henry Hub) has traded at the bottom of the range in recent years – almost certainly due to the shale gas revolution. The Japanese, on the other hand, have suffered from very high gas prices in the aftermath of the Fukushima disaster, when the Japanese closed all their nuclear facilities and, as a result, became more dependent on coal and natural gas to fuel their power plants.
Here in Europe we also appear to have paid ‘over the top’ for natural gas in recent years – at least when compared to U.S. prices. Apart from the annoyance associated with paying substantially more than our U.S. friends for heating our homes, the higher gas prices in Europe have a serious economic effect, and one that is not good for Europe. Natural gas is a major source of fuel for power plants all over the world, so higher natural gas prices here in Europe translate into higher electricity prices. Needless to say, electricity is a major cost in many industries, and therefore the price of it affects competiveness.
The incidents we are referring to may impact the price of natural gas both positively and negatively without necessarily having a major effect on oil prices (a potential war between Sunni Saudi Arabia and Shia Iran being the main exception) and could include:
· An escalation of the Ukrainian crisis (NG prices in Europe to rise – possibly dramatically so).
· A reversal of the non-nuclear strategy in Japan and/or Germany (NG prices in Japan and/or Europe to fall).
· A sudden deterioration in the relationship between Iran and the West after a period of normalisation (NG prices in Europe to rise).
· An escalation of the crisis between Sunni and Shia Muslims, which could ultimately lead to a war between Iran and Saudi Arabia (NG and oil prices to rise).
· An ISIS led attack on the gas pipeline infrastructure, which would have far greater implications than an attack on an oil tanker (NG prices in Europe to rise).
· A significant drop in U.S. shale gas production (NG prices in the U.S. to rise).
Further development of recently established shale gas deposits in the Surrey Hills (NG prices in the U.K. to fall).
In addition to these ‘one off’ incidents, it is also possibly (actually quite likely) that European politicians will become increasingly creative in their desperate attempt to create renewed economic activity, as the demographic landslide sinks European GDP growth to new depths. One such initiative may be to improve competitiveness across the European Continent through lower electricity prices, and this would open the door for Iran to supply natural gas to the Europeans.
As you can see from the chart below, neither European nor U.S. natural gas prices have, in any meaningful way, reacted to the sharp recent decline in oil prices, causing oil to be cheaper now than natural gas in Europe on a Barrel of Oil Equivalent basis.
Along the same lines, we also note that coal is now cheaper than natural gas in Europe after having been more expensive for a number of years. The global trend has been, and continues to be, in favour of using less polluting natural gas instead of oil or coal, but recent price swings may change all of that. This could make for an exceedingly interesting few years until markets ultimately find what we would call post-shale equilibrium prices on both oil and gas, and that may take quite a while yet.
As we know, commodity trading strategies thrive on volatility (unlike equity strategies most of which prefer low volatility), and we therefore think natural gas offers even better trading opportunities going forward than oil does, even if they both look quite interesting – provided the manager in question can go short as well as long.
Unless oil prices fall even further relative to natural gas prices, there is no reason to believe that oil will reverse its multi-year decline as a heating and power plant fuel. Natural gas burns much too cleanly for that to happen at the current price differential. As a result, unless the price differential widens substantially, we expect the low correlation between the two to continue, which will only increase the number of trading opportunities in the energy space.
Unless oil prices fall even further relative to natural gas prices, there is no reason to believe that oil will reverse its multi-year decline as a heating and power plant fuel.