Natural Gas and Oil Prices at Historic Spreads

April 2013

 

 

Insights by Péter Simon Vargha
Chief Economist - Hungary, MOL Group


 

Oil prices: Despite some downward pressure, oil prices seem pretty stable at the moment; volatility has been low by historical standards. What will happen to oil prices in the summer of 2013 is still an unknown, but few are projecting big swings. Non-OPEC supply has recently tended to surprise on the upside, driven by the unconventional oil boom in the United States, but disruptions elsewhere and the reductions in Saudi Arabia’s production have so far counterbalanced that. In the longer run, the further expected boost to non-OPEC supply and weak demand could force oil prices lower, to below 90-100 USD/bbl. However, a price collapse does not seem likely, as it would induce production cuts from high marginal-cost fields and political instability in revenue-dependent exporter countries. On the other hand, any supply disruption could push Brent back into the $125 territory we saw in early 2012.

Speculation vs. fundamentals: Global volatility in energy markets is often blamed on speculation. There is no evidence whatsoever that the prices are determined by speculation (in the medium run -- and for speculators the medium year is significantly shorter than one year). ‘Speculators’ do not lead, rather they follow price movements, and thus they often lose money because they buy high and sell low. Fundamentals (supply and demand conditions) can account for the majority of the ups-and-downs on oil markets. This is because both supply and demand in energy markets is generally insensitive to price changes in the short run (they are inelastic): it requires large swings in price for supply and demand to adjust. This is evident in the case of the natural gas markets in the US: demand could only absorb the significantly increased production at extremely low prices.

World prices for oil: Oil prices are determined on the global market unlike natural gas prices which depend on supply and demand conditions in several regional hubs. Nevertheless, one of the benchmark oil prices, West Texas Intermediate (WTI), isn’t currently a good indicator price because of local glut and transportation bottlenecks of oil inside the United States. WTI is sold at a sizable and historically unprecedented price discount versus other crudes (like Brent, the most often used international benchmark). Still, the US consumers have to pay the larger (global) prices, because the product prices are determined by the cost of alternative supplies.  Thus, for business decisions, it might be useful to not consider WTI prices alone: Brent is now the better global indicator price for oil. The spread between WTI and Brent is not likely to be permanent. There are huge financial incentives to ease the oil transportation bottlenecks: as pipelines are built (or reversed), the spread will decline.

Natural gas prices: Discovery and utilization of shale gas has led to a massive reduction in natural gas prices, especially in the North American market. Despite the price collapse, supply in the United States has increased, as unconventional oil fields also produce some associated gas as a by-product. Because natural gas prices are much higher in Asia as well as in Europe, there are incentives to export the gas: new facilities to export natural gas in the form of LNG will be built in the United States. Once the capacities are there to export LNG, U.S. natural gas prices could increase significantly, (again, because of the inelastic supply and demand). In the long run, as LNG capacities increase, natural gas will be traded on a global scale, leading to a convergence in regional prices.

 

About the author: Péter Simon Vargha, Chief Economist for Hungary at MOL Group, an international oil and gas company, conducts economic analysis of the macroeconomic environment as well as global and regional energy markets. He blogs regularly on energy and economics issues.

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