A warm winter doesn’t help the price of natural gas catch up at all with the price of oil. Warm winters mean that people use less of the stuff to heat their homes. It means higher inventories of natural gas. So even though the price of oil soars, the price of natural gas languishes. Old salts of the energy markets steer by the lights of a roughly 6-to-1 ratio between the prices of oil and natural gas. Today, that rate is closer to 13-to-1. Either oil is expensive or natural gas is cheap.

I think natural gas is cheap. I think it’s one of the best buys on the commodity menu right now. There are a few things that make me comfortable with the idea that those rich natural gas inventories won’t last much longer.

For one thing, as Grant’s Interest Rate Observer recently pointed out, Americans are living in bigger and bigger houses. Natural gas is a popular fuel to warm them. The amount of gas Americans use to heat their homes is rising per unit of cold. Grant’s quotes Leigh Goering, who runs a natural resource fund for Chilton. Goering says, “We’ve reached a point where we need warmer-than-normal winters for the system to operate properly.” And if the forecasters are wrong and we get a good old-fashioned cold winter? The imagination reels. Suffice to say, the price of natural gas will rise.

The size of homes was an interesting angle I had not considered before. It’s like an echo (or an aftershock) of the housing boom. The great housing bubble financed bigger and bigger homes that are costlier to live in. Even though the boom has turned to bust, its effects will linger on as a drag on America’s pocket books for years to come.

The second big issue is the new energy bill, which was kind to ethanol, to put it mildly. The bill requires a five-fold increase in ethanol production by 2020. The popularity of ethanol is one of the best things that ever happened to the natural gas industry.

That’s because ethanol is a great natural gas guzzler. Most ethanol distilleries burn it to make ethanol. And we have many new ethanol facilities coming online in 2008 — the vast majority of them will burn natural gas. But there’s more. American ethanol producers also need a lot of corn. Corn is also the biggest consumer of fertilizers among the big row crops. Fertilizers can make up 40% of the cost to produce corn. And some 90% of the cost of fertilizers depends on the price of natural gas. It’s a double whammy. Making ethanol itself burns gas, and producing the corn burns even more of it.

Finally, there are a number of new utilities coming online that burn natural gas. In 2000, nearly 95% of the new electric capacity in the U.S. burned natural gas. This has lead to a surge in natural gas usage post-2000. (See nearby chart titled “Natural Gas — Running a Hot Second.”) Since natural gas burns cleaner than coal or oil, it’s in an enviable position in a world suddenly highly conscious of its carbon emissions:

Add all that up and you’ve got a healthy backdrop to the demand for natural gas.

Sincerely,

Chris Mayer
February 25, 2008

P.S.: This is a theme that I introduced to my Capital & Crisis readers last year. We have already seen one of our natural gas plays shoot up 36% in just a few months. But we aren’t done yet. I expect to see that one rise even further as people start to realize this trend.

The Market is Severely Undervaluing Natural Gas was originally featured in the Penny Sleuth.