Think of the oil and gas markets as a two-person play in which the actors have suddenly swapped costumes.
Over the past four weeks, the price of West Texas Intermediate, the North American benchmark oil price, has declined 15 per cent. But in a remarkable plot twist, natural gas (at Henry hub) has gained 42 per cent. The latter has donned a set of bull horns it hasn't worn in more than a year, while oil is now clad in brown fur.
We'll be watching this developing scene with interest – it's a complicated plot. But North American investors should know something interesting about this play: Both actors can't dress up as bears.
Pundits have been quick to blame oil's bearish retreat on economic woes, starting with the never-ending debt situation in Europe. But the plotlines connecting Athens and Madrid to oil centres like Riyadh, Houston and Edmonton are thin. Europe's economy and its oil consumption have not been correlated for years, so why should oil prices be falling on the euro zone's troubles?
But there is a tangled thread lurking in the script: If westerners are unemployed, they can't buy as much stuff from China, which means the Chinese economy loses momentum, which means fewer people in Beijing are able to afford a gas-guzzling car – which, ultimately, means global oil prices turn bearish.
Europe, in fact, is far less important here than China, because half of all new oil consumption emanates from the Asian giant. Yet the sketchy numbers that track China's economy have been slowing recently and it's noteworthy that global oil demand has not expanded much in the past year. Overall growth on 89.5 million barrels a day is now tracking less than 1 million barrels a day. Except for 2009, the year of the financial crisis, it has been many years since world oil consumption grew by less than 1 million barrels a day.
This tepid global appetite, combined with momentum on the supply side, is contributing to oil's newly bearish character.
At the same time, natural gas has surprised the audience. A 35-per-cent jump in demand from power generators, combined with stagnant production from U.S. gas fields, is helping to burn off the staggering 800 billion cubic feet of surplus storage that accumulated over the past warm winter. Eager market participants are not waiting for that to process to run its course, however. Benchmark U.S. prices have already risen, from $1.90 to $2.70 per thousand cubic feet in one month. Other positive leading indicators, such as declining rig counts, contribute further to natural gas's newly bullish role.
The most intriguing part of this play is that a bearish oil price performance reinforces a bullish price trend for natural gas. That's because natural gas is produced from oil wells too.
Indeed, one of the principal reasons for the steep drop in natural gas prices in recent years has been "associated gas," or gas that bubbles up when pumping oil. As the number of oil rigs has risen in North America – from 200 to 1,600 in three years – there has been a surge in associated gas production. It was up 2 billion cubic feet per day in 2011. An additional 3 Bcf/d is expected in 2012. Right now, the U.S. produces 9.0 Bcf/d in associated gas, which represents 12 per cent of North American production. Without associated gas, overall continental natural gas production would decline – triggering higher prices.
So it's important to realize that weaker oil prices, if sustained, will tend to dampen the zeal for aggressive oil drilling, thus reducing natural gas production.
The plot is indeed complicated, but all you need to know is that there is only one bear suit possible: If you are bearish on oil, you have to be bullish on gas.\
Peter Tertzakian is chief energy economist at ARC Financial Corp. in Calgary and the author of two best-selling books, A Thousand Barrels a Second and The End of Energy Obesity. This is his first column for The Globe and Mail.