Today's Trends: Rebounding Natural Gas, Substitution Effect

Narrowing spreads between natural gas and residual fuel oil suggest natural gas futures should move higher over the remainder of the summer. Since May 2010 the spreads have narrowed 17%. Another 2.5% decline in spreads would drive natural gas 20% higher to $5.45 versus yesterday's close of $4.55. According to researchers at Rice's Baker Institute for Public Policy, the importance of the relationship between U.S. natural gas and residual fuel oil rests in these commodities ability to compete against one another as a fuel source for power generation.

Historically, this relationship has flown out of balance in the short-run due to supply shocks, adverse weather conditions (i.e. Hurricanes, an extreme summer, or a harsh winter), rapid swings in storage levels, or other types of seasonal variances. Typically natural gas pricing has been more volatile than residual fuel oil. Abnormally high natural gas storage levels (over the past two years due to prolific shale gas production) have exacerbated what we would consider a pricing imbalance relative to historical patterns. YTD the correlation between the two commodities is a negative .25, considerably out of synch with historical patterns as illustrated by the correlation table below.

GRAPH: Commodity Correlation

Since late January until early May of this year the spread between the two commodities has widened in favor of residual fuel oils. Specifically, natural gas futures followed their seasonal pattern dropping nearly 25% over the spring months. Residual fuel on the other hand experienced a 19% gain. Reversing course since early May, natural gas is up 14% and residual fuel oil is down 13%. As the available substitution effect drives the long-run relationship closer to balanced levels (i.e. tighter spreads) between the two commodities, we would anticipate greater demand for natural gas providing the catalyst that sparks price improvements.

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Brent Crude Oil : $53.87/BBL 0.48%
Light Crude Oil : $50.73/BBL 0.79%
Natural Gas : $3.33/MMBtu 2.14%
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