Lower Oil Prices?

February 08, 2012 | Nat Kellogg, CFA, President

Domestic energy production has experienced a renaissance over the last few years, mainly driven by natural gas production. While oil prices hovered around $100/barrel for most of 2011 natural gas prices hit lows not seen since the 1990’s. As this chart shows, the relative price of oil to natural gas (shown in gold) was fairly stable during the 1990’s and most of the 2000’s but has soared over the last few years. In the short term some divergence is understandable, but over the long term these two energy sources are substitutes and we would expect to see energy consumers switch from oil to natural gas given the price differential.

The line in gray shows the number of natural gas drilling rigs in the U.S. and the explosion of drilling in 2006 and 2007 led to the increased production and lower prices we see today. What is also interesting is natural gas drilling activity has remained fairly stable over the last two years while oil drilling activity has reached levels not seen in the last twenty years (black line). Will the increase in oil drilling lead to more production and lower prices? If natural gas is any indication, Americans might see more oil production and lower prices at the pump in the years ahead.