Natural Gas as a Substitute for Oil?

I recently read an interesting post by Carl Futia which explained why he thought that Crude Oil would soon drop in price. Part of his thesis was based on the fact that Oil is a commodity, and thus has substitutes (namely, natural gas). This piqued my interest, because at first glance, I hadn’t made the connection that oil could be substituted for NG; after all, you can’t just pump up your car with NG!

After some research, however, I agree with Futia’s assertion that NG can substitute a significant portion of energy consumption, which will cause oil prices to drop, and natural gas prices to rise. To explain this dynamic, I’ll start by showing the extent to which NG can be substituted for oil. Then, I’ll show how a small change in supply/demand for a commodity can have a large effect on price. Finally, I’ll highlight whether the market would agree with my assessment.


Can Natural Gas be Substituted for Crude Oil?

This web site has a very effective graphical representation of energy consumption in the US (which I’ll use as a proxy for the OECD countries’ consumption pattern). From that chart, you’ll notice that Industrial uses of energy account for approximately 1/3 of total energy consumption (21.8 Q BTU out of 68.5 Q BTU). Furthermore, Industry sources its energy equally from petroleum (oil, 35.7%) and natural gas (34.8%). Because most industrial uses of energy require heat energy (whether it be for smelting or generating electricity), petroleum and natural gas can be interchanged effectively. This is in stark comparison to transportation, in which the prevalent internal combustion engine infrastructure disallows substitution of fuels.

Based on these numbers, there exists a significant potential to substitute NG for petroleum as an energy source. A back-of-the envelope calculation suggests that global petroleum demand could drop by 1m BBL/day if the percentage of petroleum used for industry dropped to 30%, and NG rose to 39%. The question, thus, is whether a 1m BBL/day drop is significant enough to affect prices.


How dramatically do oil prices react to changes in demand?

To answer this question, we can look at what happened in the last economic downturn. Due to the Great Recession, Global oil demand dropped from a peak of 86.2m bbl/day in 2007 to 84.4m bbl/day in 2009, and drop of 1.8m bbl/day. As we all know, during this time, oil prices dropped from a high of $147/bbl to $35/bbl. Clearly, a nominally small decline in demand can have a large effect on prices.

Since the potential exists for crude oil to be substituted by natural gas in a significant way, one must only look at price differential to see if Industrial users can benefit from switching. Currently, crude oil trades near its record highs, at $100/bbl, while natural gas is trading near 10-year lows of $4/1000-CF. These extremes in price should offer enough incentive to trigger substitution in a significant way.


What does the market think?



The two charts show the price history for the past three years for Crude Oil (top) and Natural Gas (bottom). The bottom pane on each chart highlights the Commitment of Traders data. Notice that commercial traders are holding their largest net-short position in crude and their largest net-long position in natural gas in the past three years. Crude producers are rapidly locking in high prices and natural gas users are locking in low prices. It appears that they also believe that natural gas will soon begin substituting crude oil for energy needs, which will push up prices.

We’ve seen that there is a significant potential for natural gas to substitute crude oil in industrial applications, which would reduce oil demand. We’ve also seen that relatively small change in demand can cause large price fluctuations, and we’ve seen that the current pricing for these commodities supports a trend of switching from crude oil to natural gas. Finally, market participants are revealing that they too agree with this thesis. Natural gas seems like an intelligent investment at this point.


Personalized Pens said...

Interesting to see where the price of cruse oil is two weeks after this post.

Narayana said...

A bit higher?

Penny Stock Blog Tips Advice said...

Im suggesting that investors take a look at the exchange traded note trading under the symbol {GAZ} It tracks the price of natural gas using futures contracts. Natural gas is one of the few commodities that still a great bargain compared to other commodities.

Equity Tips said...

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Excellent post on natural gas.