Another Nasty Oil Correction Is Close at Hand
By Ian Davis
July 21, 2008

On June 16, I predicted an imminent, "nasty correction" in crude oil.

That correction may now be underway. Crude oil plummeted more than $15 in the last three days. And a lot more downside is in the works. I think oil could be headed as low as $50.

But today, let's talk natural gas...

If oil crashes, natural gas will fall, too. Natural gas is like crude oil's younger sibling. The natural gas price shadows the price of crude oil wherever it goes.

The two have a follow-the-leader relationship because about 18% of natural gas usage can be switched to petroleum products. Also, drilling these two forms of energy requires many of the same resources... like geologists, drill-rig operators, and rigs.

The following chart shows the close relationship between crude oil and natural gas.

Where Crude Oil Goes, Natural Gas Follows

As you can see, the two energies rarely diverge by much. However, the price of crude oil has outpaced natural gas in the last couple of years. That's not unusual... the natural gas price often lags the price of crude oil.

Like an older brother, the crude oil market is much bigger than the natural gas market. So the price of crude oil is determined on the world stage. But natural gas prices are determined by region. So the price of crude oil drives the natural gas price and not vice-versa.

According to a Department of Energy study, if crude oil pops up 20%, natural gas climbs 16% over the following year. Eventually, natural gas rises the full 20%. But the price rises more slowly as the fuels return to their normal relationship. (On average, a barrell of oil costs eight times as much as 1 million BTUs of natural gas.)

Why Oil May Be Headed for $50 The Key to Making Money in Oil Stocks This Year...

So natural gas has been playing catch-up for the last two years. Now that crude oil is falling, we'll see the same thing in reverse. Natural gas will also fall, but more slowly than crude oil.

Let's say crude oil does fall to $50 (a huge fall, but not impossible). That would be a 66% decline. If the historic relationship between the two fuels reasserted itself, natural gas would be $6.24 per million BTU. That's a more modest drop of 52%.

So I don't think natural gas has as much downside risk as oil... but the picture is still ugly. My advice is to stay out of both energy markets until the correction plays out.

Good investing,

Ian Davis