A recent Wall Street Journal article reported that natural gas prices are cheap relative to crude oil. The article's expert sources claim, in fact, that natural gas futures are trading at some of the steepest discounts seen in several years.

Now, it's not easy to judge the relative value of these fuels due to their pricing conventions. Oil is priced in dollars per barrel, while natural gas is denominated in dollars per million British thermal units (mmBTU). One way to rationalize prices is to reduce crude's value to its energy equivalence. One barrel of crude, on average, supplies 5.8 mmBTU. Divide crude's price by 5.8 and you'll see its thermal energy value.

Energy Equivalence 

As an example, NYMEX spot crude closed at $115.29 per barrel on August 28. The contract's energy- equivalent price was $19.88 per mmBTU. Meanwhile, the nearby natural gas contract settled at $8.05 per mmBTU, the energy equivalence of crude at $46.69 per barrel. From this perspective, natural gas is selling for 41% the price of oil.

According to the expert quoted in the Wall Street Journal piece, the gas discount, given current supplies, ought to be at the 60-70% level. The Journal cites new production technologies increasing the pace at which gas can get to market while demand growth slows. All of that, it seems, has widened the discount.

Naturally, there are times when natural gas provides BTUs cheaper than crude and, at other times, at a higher cost. Since 1994, crude has traded at a premium as large as $13.11 per mmBTU, or $76.04 per barrel-equivalent, to a discount of $5.41 per mmBTU ($31.40 per barrel-equivalent).

Going into the fall, crude oil typically commands an energy-weighted premium over natural gas, but that usually wanes as winter approaches. In other words, natural gas prices tend to approach - and sometimes, surpass, those of crude oil in the cold weather season.

Crude Oil/Natural Gas Spread ($ per mmBTU)

Intuitively, that makes sense. After all, gas demand tends to be highest in winter and while refiners' demand for crude diminishes. Annual maintenance programs usually shutter refineries in the winter. Increased gas demand keeps price firm while a slack market for crude allows prices to languish.

We've discussed petroleum market seasonality in several Hard Assets Investors articles, including "Time For Crack Spreads?". Speculators typically buy the spread (long crude oil/short refined products) on Hallowe'en and hold the position until mid-December.

Seasonal Contraction

The most reliable seasonal tendency in the crude oil/natural gas spread is the contraction between September and December. Buying natural gas futures on the first business day of September, against the short sale of crude oil futures, and holding the position until the second Monday in December would have produced gains, on an energy-equivalent basis, in 11 of the past 14 years. The gains realized from the spread have outpaced losses by a 3.4-to-1 margin.

To trade the spread on an energy-equivalent basis, 58 natural gas contracts would have to be purchased for every 10 crude oil futures sold short. Unfortunately, most retail investors find it difficult to trade futures in the size required for energy equivalency and so must content themselves with trading the spread at parity, or one contract per side. Doing so brings down the win/loss ratio to a still-respectable 9-to-5, and lowers the profit ratio to 1.3-to-1. Given the risk profile of the trade, those remain pretty decent odds. There's, as well, a 40% margin credit granted by the NYMEX clearinghouse for the spread, which enhances its potential return.

Long Natural Gas/Short Crude Oil Seasonal Trade (1994-2007)

Looking at the finer-grain detail, natural gas has been the more reliable leg of the spread, winning 79% of the time, versus a winning percentage of only 64% for crude.

For those investors without the means or desire to trade futures or spreads, then, a reasonable proxy might be the purchase of the United States Natural Gas Fund (AMEX: UGA), an exchange-traded fund that tracks NYMEX natural gas futures. UGA was launched in February this year and trades an average 24,600 shares a day.

United States Natural Gas Fund (UGA)