How Does Crude Oil Affect Natural Gas Prices?

Traders who are interested in commodity trading should understand how crude oil affects the price of natural gas. Both are highly traded and play important roles in deciding global market health and its movement.

Though earlier, their prices were linked together through price correlation, after the 2008 financial crisis, they became unlinked due to the rise of hub-based pricing. However, there is still some sort of correlation between the two fuel types, and during certain conditions, changes in crude oil prices affect natural gas rates and vice versa.

In this article, we will examine how both crude oil and natural gas depend on each other and how their prices are affected.

Overview of Crude Oil and Natural Gas as Commodities

Both crude oil and natural gas are highly tradable energy commodities and account for more than 50% of primary energy consumption on a global scale.

Natural gas is an essential fossil fuel that is used for generating electricity, heating, and industry, while crude oil is used primarily in transportation and manufacturing. Though these two are considered highly tradable assets, they are known to be extremely volatile, and changes in geopolitics and supply-demand volumes can considerably impact their prices, subsequently affecting the global markets.

A drop in their prices may lead to higher consumer spending and market growth, while a spike would cause inflation. Crude oil is easier to transport compared to natural gas due to its liquid form. Both are traded on commodity exchanges, such as the Multi Commodity Exchange of India (MCX).

Impact of Crude Oil Prices on Natural Gas Futures

Crude oil and natural gas prices can be connected, but the relationship is not always strong. Here are some ways crude oil prices can affect natural gas futures:

Historical price link: Crude oil and natural gas have often moved in the same direction because they are both energy commodities and can sometimes be used as substitutes.

Higher oil production: When higher oil prices encourage producers to increase oil output, the supply of associated natural gas can also rise. This can put downward pressure on natural gas prices.

Fuel switching: If crude oil and related fuels become expensive, some users may shift towards natural gas where possible. This can increase demand for natural gas.

Different market drivers: Natural gas prices are now more closely influenced by factors such as production, storage levels and weather. This means gas prices may not always respond strongly to changes in crude oil prices.

Weather matters: In the short term, heating and cooling demand can have a bigger impact on natural gas futures than crude oil prices.

Regional differences: The relationship between oil and gas prices also depends on the market. It can be stronger where oil is used as a pricing reference or where the two commodities share infrastructure.

Overall market sentiment: Large movements in crude oil can sometimes affect investor sentiment across the energy market, which may also influence natural gas futures.

Why Can Crude Oil Influence Natural Gas Prices?

We understand how natural gas and crude oil are linked to each other. Now, we will examine why the natural gas price is influenced by crude oil:

Associated Production: Natural Gas is a byproduct of crude oil production, especially in shale formations like the Permian Basin. To meet the rising demand, oil producers drill more to counter the high oil prices, leading to a higher production of associated gas. Higher supply of natural gas can lead to a fall in its price despite the increase in oil rates.

Interchangeable Usage: Both crude oil and natural gas can be used interchangeably in various energy sectors. This means if the price of oil rises, consumers can shift to natural gas, creating a rise in demand.

Historical Indexing: The correlation between crude oil and natural gas has weakened over time despite the latter being indexed to the former earlier. However, occasionally natural gas prices follow oil market trends.

Production Costs: Production components like labour and machinery for both oil and natural gas are similar. This means when the crude oil price increases, so does the demand for rigs, leading to a rise in operational costs across both industries. This may cause the rates of both types of fuels to spike.

READ MORE: Why is silver more volatile than gold?

When Crude Oil and Natural Gas Move Together?

As established earlier, crude oil and natural gas do not move together. Certain conditions need to be met for both fuel prices to move simultaneously:

Macroeconomic Changes: Geopolitical tensions, changes in economic policies, or sanctions affect the price of both crude oil and natural gas. For example, the ongoing fight between Iran and the USA, which has led to the shutdown of the Strait of Hormuz, has led to both crude oil and natural gas prices being impacted. Similarly, an economic slowdown also causes demand to fall, reducing industrial activities and resulting in a price drop.

Overlapping Demand Cycles: Weather changes also affect the price of both crude oil and natural gas. This happens during winters and summers, when transportation fuels and heating fuel rates rise simultaneously, impacting both fuel costs.

When Do Crude Oil and Natural Gas Prices Decouple?

Crude oil and natural gas prices decouple a number of times under certain conditions. Largely, both these fuels trade independently and are hardly correlated:

Changes in Shale Gas: Earlier, natural gas was considered a byproduct of crude oil until horizontal drilling led to a massive shale boom in USA, leading to the discovery of gas reserves which were independent of crude oil production.

Crude Oil is Global, and Natural Gas is Regional: Crude oil is traded and transported globally. For example, disruption in Venezuela may cause massive crude oil price spikes. Natural gas, on the other hand, is localised and requires locally laid pipelines for transportation.

Weather Changes: If changes in weather can cause price changes in crude oil and natural gas to be linked, it can also independently cause shifts in price movements as well. For instance, natural gas consumption is heavily linked to temperature. Heating during winter and air conditioning power generation during summers cause its price to change regardless of how crude oil performs.

Market Shift: Global markets, especially European and Asian markets, have matured and moved from oil-indexed contracts to gas-on-gas contracts like Japan-Korea Marker (JKM) and Title Transfer Facility (TTF), structurally weakening the price link between both fuels.

Conclusion

Crude Oil and natural gas remain two of the most important commodities in the energy sector. However, both have individually evolved significantly; earlier, the price of natural gas was linked to crude oil; today, modern pricing is comparatively nuanced.

Due to rising demand-supply, hub-based pricing, and an increase in associated gas production, natural gas trades independently and largely bears no correlation with crude oil.

Commodity traders should understand the dynamics of both crude oil and natural gas, how their prices are affected, and what happens in the global market due to shifts in supply and demand. This can help investors navigate market volatility, assess geopolitical conditions effectively, and execute better trading decisions.