Master BTU Contract

1/4/10 – Happy New Year

In my reports, I have noted that in the long run, all forms of energy must compete on a BTU basis with differentials recognizing 1) the form preference of the source of energy, 2) the quality of that form of energy, and 3) the location or transportation cost of that energy. The master or basic BTU contract has been oil, as it is the most globally traded, readily abundant (in spite of its pending “peak”), transportable, and fungible form of energy. In this sense, all energy contracts traded in the market could implode and be reduced to these basic contracts.

Now I am pondering this assumption of oil’s role as this master BTU contract. Not necessarily in today’s market, but in the future.

As has been noted way too many times, natural gas has been mislabeled the “fuel of choice.” However, from a carbon footprint perspective, gas may be the hydrocarbon of choice. Now its attractiveness may add the component of price. Liam Denning, in a WSJ 6/19/09 opinion, made the analogy of junk food being cheap calories and natural gas being cheap BTU’s. Calories, BTU’s: it’s all energy.

Now we are seeing truly breakthrough technologies in recovering natural gas from shale. According to the Potential Gas Agency in the U.S., such a technological breakthrough, specifically in shale production, accounts for over 600 TCF of its 2008 technically recoverable reserves of over 1,800 TCF from its 2006 estimate of just over 1,300 TCF. However, without belaboring the point, the regulatory and economic environment must still allow those resources to become reserves and be produced.

The global energy markets are also seeing a continued expansion in LNG in spite of current low natural gas prices. Much of this expansion reflects the long lead-time needed to construct liquefaction and regasification facilities and the added value realized from being able to monetize natural gas liquids that might otherwise be stranded. LNG can be a low cost supplier, and with this new transportability, it has the flexibility to seek the best markets just as oil has over the years.

While domestic gas has an advantage over LNG of not having to cover the “refining” cost of liquefaction and regasification, the whole natural gas market is evolving on a comparative basis with oil, that must be refined into usable products in its cost structure. Even the Alaskan arctic gas line seems to have new life, if it can compete in this new lower price environment.

Nevertheless, natural gas is a hydrocarbon, a clean hydrocarbon, but an energy source that is in itself methane) a greenhouse gas and when burned adds CO2 to the environment.

Point to Ponder

With this abundance of natural gas, its relative environmental desirability and its improved transportability, could natural gas become the new long-term master BTU contract? After all, natural gas at least seems to reflect the laws of supply and demand.

Currently oil is still dominant in the mind of the players in the market as they continue to seek protection in established commodities. In addition old habits are hard to break and oil is looked at as a leading indicator of economic recovery.

However, it will be very difficult for the current speculation in oil to pull up the rest of the energy complex in light of the realities of continued financial weakness.

It is only recently that the relationship between oil and gas prices has deviated from their long-term relationship. This is predominantly caused by:

  • A speculative component in oil tied to the anticipation of a global recovery from the recession and the associated jump in demand for oil especially from the emerging and recently emerged economies;
  • And the flight to gold and black gold because of the weak dollar.

A more likely scenario is for natural gas to pull oil back down to its BTU parity as natural gas plays a bigger role in whatever economy we are dealt. Could such a pull establish natural gas as this master BTU contract?

We can use the relationship in the 3D chart below to look at scenarios for what we would expect to see for Natural Gas based on a perception of oil (if we still believe that oil represents the Master BTU Contract).

In other words, if oil prices are forecast in the $60/barrel to $80/barrel range, we would expect from history that gas prices would trade between $3 and $7/mmBTU. This is a cut from that the 3D distribution shown above. Again, as a caveat to any user of a forecast or to one relying only on history, extreme swings outside this range are possible.

As of December 31, 2009 WTI (West Texas Intermediate) was about $80/barrel. Absent a fundamental change in the markets, we would expect statistical pressure on oil prices to decrease over the long term toward the mean value between $55 and $75. If history were to repeat itself, we would expect gas prices to also come down from their levels of "irrational exuberance" (thank you again, Mr. Greenspan) to trade at a ratio between 0.9 and 1.1 of parity. Since the post-Katrina peak of $15, this has been the case, as natural gas has fallen back into the range of $5 to $7/mmBTU. To no one's surprise, when oil prices were in the low range (mid-teens), as traded at close to parity on a heat-equivalent basis with oil.

The following is a plot of the futures for oil and gas at the close of the market on December 31, 2009. I have added the blue line that could bring oil back to a hypothetical price of natural gas in the near months to show how near-term reality of supply and demand in this current recession, and future speculation in economic recovery could play out without turning speculators once again into scapegoats.

And what does this do for energy policy? The more likely low natural gas price regime from its new abundance could have a heavy negative impact on new emerging fuels and make them even less economic than they already are. Indeed, natural gas at the $4/mmBTU level even brings a lot of coal into question.

If we switch the independent and the dependent variables, the 3D histogram looks like the chart below.

This would suggest that for a range of from $4.00 to $5.50 gas we would expect a range of $50 to $65 for oil, implying that there is a current premium of $5 to $15 for global speculation and oil’s negative (like gold’s) correlation to the strength of the dollar.


For further discussion of this, other related topics and a derivation of the 3D probability distribution concept please see my report Accountability in Energy Price Forecasting – What a novel idea available from PennEnergy Research in late January.

Click here for more information about Confessions of an Energy Price Forecaster: A 12 Step Program to Enlightenment

Click here for John Tobin's full bio


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