1. Energy Output - The amount of energy output is referred to as BTUs, or British Thermal Units. This scientific measure allows us to compare different methods of energy consumption to see which is more efficient. The amount of BTUs contained in a barrel of crude oil is roughly six times as many as those contained in one of the natural gas units that are traded on the NYMEX exchange (this is measured in MMBTUs which stands for one thousand thousand BTUs, or one million BTUs). Using this method, it is possible to work backwards to see the relative value of both commodities. Using simple division we know that if this energy output ratio is greater than 6:1, then natural gas is relatively undervalued from an energy standpoint as the cost  of one barrel of crude oil would be the equivalent of more than six units of natural gas. This also works in reverse. If the energy output ratio is below 6:1, then we know that crude oil is undervalued relative to natural gas as six units of natural gas would buy you more than one barrel of crude oil.
2. Historical Trading Ratio - Over periods of time the actual trading ratio has more often than not been something besides 6:1. The reason for this is the infrastructure substitution effect. Because crude and natural gas cannot be substituted in every single circumstance, there must be a premium placed on the market ratio of the two prices. In the case of our modern day economy, the bias goes towards crude oil as our infrastructure is more heavily built around the consumption of crude oil. As you can imagine, large shifts in infrastructure may cause the trading ratio to change. This has happened multiple times in the past, but the last major shift occurred around the 1980s. Some investors believe that another shift may be coming due to new policies that could be put in place by the President-Elect Barack Obama. From 1980 till today, the actually trading ratio of a barrel of crude oil to natural gas has been averaging 8.5:1. The same math applies for this ratio as the energy output ratio, but the new “crude biased” ratio applies. Most of the energy traders and experts I have spoken to have used this historical trading ratio as opposed to the energy output ratio. Another important point to remember is that depending on your time period, the average historical trading ratio can change drastically. As you all have heard before, there are three types of lies: lies, damn lies, and statistics.

Using NYMEX prices from last week we can see the ratio stands at roughly 6.5:1 ($39 crude oil, $6 natural gas). By the energy output ratio, we would say that the commodities are both valued correctly relative to each other, but by the historical trading ratio we would say that crude oil is undervalued when compared to natural gas.

Advantage: Crude oil at the time of this writing, but shifts in relative valuation ratios takes place regularly.

Conclusion

All in all, it seems as if there is no clear winner to the battle. I’m going to award crude oil the temporary winner due to its infrastructure advantage, relative price, and the fact that it probably has less moving pieces involved for investors to analyze. Obviously, almost all of these variables I have written about in this and other articles are constantly moving, so it is important to be on top of the current macro and micro-economic news. Another important factor to remember will be the movements in the U.S. Dollar, although that won’t have an effect when analyzing crude oil and natural gas as they are both priced in U.S. Dollars (if you use the NYMEX gas prices). The key to successful commodities based investing is to be continually adapting to the new and ever-changing economic environment.

Winner: Crude Oil at the time of this writing.

- Charles W. Petredis

Disclosure: The mutual fund the author manages, the author, and the author’s family are all long CHK.