2012-12-20 / Columns

Perryman Report

Lots of questions, some answers about cheap gasoline
by Dr. Ray Perryman

I do a lot of speaking throughout the year, and for the past several weeks, I’ve been in the midst of my annual Economic Outlook Conference series (the 29th annual, by the way).

One question I’ve heard a lot in the Q-and- A following the events involves the relatively large difference between oil prices and natural gas prices. In other words, “why is gas so cheap?”

Based on the energy content in each fuel, a barrel of oil is equal to about 7 to 8 thousand cubic feet (mcf) of natural gas. So $3/mcf natural gas should correspond to an oil price of about $24 per barrel. Or $80/barrel oil should go with $10/mcf natural gas. However, what we have now is $3/mcf gas…and $80/barrel oil (in round numbers).

The primary reason for this disconnect is that oil is a global market, but natural gas is a national one.

There has been some importing of natural gas and, more recently, moves to export it in the form of liquefied natural gas (LNG). However, the primary determinants of natural gas prices are the supply and demand in the United States alone.

The sluggish economy has worked to reduce demand for natural gas. At the same time, enhanced recovery methods and massive shale discoveries and production have led to enormous growth in the available supply.

As a result, we are now in a position where we have more natural gas available than we need. As predicted by economic principles, the price has fallen.

If oil and natural gas were perfect substitutes, you’d see people in the United States switching from using oil to using more natural gas to take advantage of the potential savings (which would then eliminate the excess supply over time).

However, it takes time to switch fuels. For example, natural gas-fueled vehicles have been around for decades, but aren’t generally available at your local dealership. The desirable environmental properties of such cars and trucks have earned them a place in both public and private fleets, but it’s a little more difficult for the average household to make that change.

Think about how many gasoline pumps you pass every day compared with natural gas fueling stations.

The global nature of the oil market ties its price not only to what is going on in America, but also elsewhere. With rising demand in a number of emerging economies, the overall need for oil as a fuel remains high, keeping prices elevated. Many countries could use natural gas, but our ability to export it is only now developing.

Oil prices are also supported by fears that tense situations in various oilproducing regions could escalate and lead to a supply shock. In effect, there is a “risk premium” being priced in, and any sign that political situations in the Middle East, Venezuela, and other locales is changing for the worse could cause prices to jump.

The national nature of the natural gas market also tends to make it more volatile. In August 2005, the price stood at $6.48 per mcf. It jumped to $10.33 only two months later, a rise of almost 60 percent in just two months. A few months later, it was back down.

In July 2008, just before the national downturn took hold with a vengeance, the price peaked at $10.79. Less than a year later, it was $3.18. A severe winter storm can cause prices to jump, a bit of a glut and they crash. As an export market develops, these swings will tend to moderate, which is good news for both producers and consumers.

Over time, the natural gas market is likely to become more global, with the United States becoming a net exporter within a decade (according to some market watchers).

This evolution will diminish the gap between oil prices and natural gas prices. Until then, enjoy the cheap gas while you can!

Dr. M. Ray Perryman is President and Chief Executive Officer of The Perryman Group (www.perrymangroup.com). He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.

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