Oil to Natural Gas Ratio: Reaching the Extremes

The last time this happened, investors had the chance to pocket 83% gains in about four months time.

They could have done it safely. This has nothing to do with the overall market direction.

Best of all, it’s consistently lucrative. It has paid off an average of 112%.

But it doesn’t happen often. This opportunity has only arisen three times in the last five years.

Right now it’s about to happen all over again. Here’s the set up.

Physics 101: Energy is Energy

Oil prices have been steadily climbing over the last few months.

Since the start of the year oil prices have climbed more than 5%. The combination a recovery in demand, OPEC successfully capping output, turmoil in Iran, and artificially low interest rate-fueled speculative buying has pushed oil above $80 a barrel.

Natural gas, on the other hand, hasn’t fared nearly as well.

Large stockpiles, exceptionally warm weather, and a host of other factors have helped push natural gas prices down. So far this year natural gas prices are down 28%.

A situation where oil prices go up and natural gas prices go down cannot and will not last.

You see, oil and natural gas are highly correlated over the long run.

It’s basic physics. Oil and natural gas are both hydrocarbon energy sources. When they are burned they produce a certain amount of energy. The energy values of each do not change. The energy value of a barrel of oil has always been the equivalent of about six thousand cubic feet (Mcf) of natural gas.

As a result of the value of the energy, oil and natural gas prices have been highly correlated over the long run.

The short-term, however, is a much different story. Sometimes events like cold weather, hurricanes, or other factors push natural gas prices higher and oil holds steady. Other times oil prices will climb when OPEC cuts production or during periods of heightened geopolitical turmoil while natural gas prices hold steady.

Since oil and natural gas prices are so volatile, the ratio of oil and natural gas prices varies greatly.

This volatility naturally creates opportunities. And it creates great opportunities for disciplined investors patient enough to wait for the extreme situations.

Right now, the oil and natural gas markets have hit one of those extremes.

Reaching Extremes

The long-run oil/natural gas ratio tends to stay within a range between 6-to-1 and 12-to-1. That means the price of a barrel of oil is usually is the same as six to 12 Mcf of natural gas.

Occasionally it steps out of that range. But, as the chart below of oil/natural gas ratios shows, the ratio always returns to that range over time.

As you cans see, the range has been volatile over the years.

Sometimes the ratio is too high and sometimes it’s too low. Every time it has gotten very far out of line, it always returns to the range.

For example, the red arrow to the left shows what happened when Hurricane struck the Gulf of Mexico. At the time oil prices climbed. But natural gas prices soared. The oil/natural gas ratio fell to 5-to-1 as natural gas prices outpaced oil prices.

The situation did not last. And it created a great hedge opportunity for investors to make 120% over the next few months as the ratio climbed from 5-to-1 to 11-to-1.

The second red arrow shows when the oil/natural gas ratio fell to the bottom of the range at 6-to-1. At that time the credit crunch sent the markets into a tailspin. Between July and October 2008, oil prices fell 70%. Natural gas prices, meanwhile, only fell 50% from their highs.

Once again, the extreme situation where natural oil was falling much faster than natural gas created another situation where investors could turn a nice, quick profit betting the ratio would return to its norms. IN this case the ratio rebounded from 6-to-1 to 14-to1 in four months. That would have been good for a 133% profit.

Then the green arrow in the chart shows what happened as the markets recovered from the credit crunch. An unseasonably warm winter pushed natural gas prices to eight year lows and a speculative run-up in oil prices pushed the ratio to more than 22-to-1.

Oil prices were too high and natural gas prices were too low. This was the most extreme point the ratio has reached in the past decade. And it was the big reason we started getting extremely interested in natural gas at the time.

As has happened every other time the ratio reached an extreme high or low, it reverted to the mean.

In this case, oil prices continued to climb, but natural gas prices more than doubled from their lows. As a result, the oil/natural gas ratio went from an unsustainable 22-to1 down to 12-to-1 in the next four months.

Investors who themselves correctly walked away with a relatively safe 83% gain as the ratio reverted to the mean.

Now it’s shaping up to happen all over again.

Something Has to Give

The oil/natural gas ratio has hitting another extreme.

As I write, the ratio is sitting at an unsustainable 19.77 (oil – $81.85/natural gas – $4.14).

It is way too high. Something has to give. Either oil prices have to come down or natural gas prices have to go up. Given the current situation, your editor expects a combination of both.

If history and basic physics are any indication, the ratio is about to head much lower in the next few months. And the gains to be had, relative to the risk, are phenomenal.

For example, if the ratio falls to the top of its long-run range of 12-to-1 you could make 64%. If it falls to the 9-to-1, you could more than double your money.

Market Neutrality: The Best of Both Worlds

The trade is a relatively simple one. You would start by shorting oil (betting it will go down) and buying natural gas. With the popularity of ETFs like the United States Oil Fund (NYSE:USO) and United States Natural Gas Fund (NYSE:UNG), it’s easier than ever to get in on trades like this.

The trade doesn’t tie up that much capital either. Since you are shorting one and buying another with the proceeds, a trader would only need to put up a small margin requirement (the actual margin requirement depends on the broker although there are regulatory minimums). That’s where the bigger gains from without having to tie up to much capital.

It’s a market neutral trade. It’s unaffected by the overall markets. That’s where the safety comes in.

Oil prices could go up or down.

Natural gas prices could go up or down.

At this point, anyone could make a case for either one. Natural gas stockpiles are high and prices could go down. Oil prices have defied gravity up to this point too. The fundamentals don’t justify $80 a barrel, it’s too early to tell if oil prices have topped-out for a while.

That’s the beauty of this trade. It’s a hedge based on the simple principle that the relationship will revert to the mean as it has every other time.

A Big Job Needs a Big Toolbox

Now, I realize most investors are hesitant to “short” anything or get into a genuine market neutral hedge trade.

But the thing is, despite our consistent unwillingness to bet against this rally, we can’t forget history will eventually view the current rally as one of the greatest bear market rallies in history.

As a result, now is the time to start getting familiar with all the available strategies to protect and grow your wealth in a bear market.

Even though we aren’t outright bullish on stocks in general, we know as prudent investors we’ll be able to find low-risk, high-reward opportunities in lots of places.

Right now the oil and natural gas market is one of those places. The two energy commodities have become completely disconnected. But as history has shown, it never stays this far out of its historical range for long.

There are no sure things in any market. But if you think more traditional investments like stocks and bonds are too overpriced or don’t offer the reward for the risk, then finding and profiting from opportunities like these would go a long way to making you a more successful investor in the short- and long-term.

By Andrew Mickey

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