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Natural gas is cheap in relation to oil

May 12th, 2008 · No Comments

We’ve found a couple of interesting articles today on the oil and natural gas markets. Since we advise a position in InterOil, which despite it’s name is a natural gas, not (at least not yet) an oil play, we’re more than a little interested. 

The first question, by the excellent economist turned columnist Paul Krugman, has speculation driven up the oil price? Krugman answers this with a resounding no in today’s New York Times. What’s the logic?

Well, pretty simple, his logic is based on the existence (albeit low) of demand and supply elasticity in oil:

Even if this were purely a financial play on the part of the speculators, it would have major consequences in the material world. Faced with higher prices, drivers would cut back on their driving; homeowners would turn down their thermostats; owners of marginal oil wells would put them back into production.

Those reactions would have decreased demand and increased supply, and soon the price would fall back. Those reactions undoubtedly happened, but the price, far from falling back, kept on increasing.

The only way speculation can drive up the price if they actually take oil off the market. That is, if speculators actually exercise their contracts.

The most notorious example of that is a big silver ploy by the Hunt brothers a couple of decades ago. They first bought silver contracts, as a form of speculation, but to everyone’s astonishment, they exercised these contract and let the silver be shipped to their big warehouses, creating real scarcity in silver.

Normally, things are not supposed to happen this way, and we’re not aware of any real deliveries to speculators, and no hoarding elsewhere either, as inventories have remained roughly the same. Hence Krugman’s logic that it’s not speculation that drives up the price (although he concedes that it could temporarily do so).

Another article points out that there is a record amount of short interest in natural gas. This is actually very strange, because compared to oil, natural gas is very cheap, way below it’s average vis-à-vis oil (see figure below). That means that to get the same amount of energy from natural gas, one has to pay a lot less.

The author argues that he’s bullish on natural gas, and so are we, as we’ve argued more than once on this site. We are puzzled by the large short positions in natural gas and have pointed out the scarcity and price premia especially in Asia, and there are good reasons for that.

Surely, it cannot be the same people who shorted InterOil..

Tags: IOC · The Markets