Generational Arbitrage

The thankful receiver bears a plentiful harvest.” – William Blake

The primary utility of oil, natural gas, and coal is that they can be readily burned to create heat. Humans have engineered myriad magical machines that can translate heat into useful work, and the integral of useful work we can outsource to such machines has come to define our collective standard of living. But you already knew all of that.

As humans, we generally care much more about getting the work done than the source of the heat, and the privilege of getting to choose between sources for any reason whatsoever—carbon counting concerns included—is the surest sign of abundance. There is also a certain degree of fungibility between the hydrocarbon fuels, either because some machines are flexible in the fuels they can accept or because different fuel-specific machines compete to perform the same work. This is how countries toggle between natural gas and coal to produce electricity, for example, and why power producers often quote hydrocarbon sources in megawatts (MW).

The machine that powers the machines | Getty

Given the highly inelastic nature of hydrocarbon pricing, it does not take much for price moves in one fuel to impact the others, and a few percentage points worth of switching capacity is almost always enough to close energy arbitrage opportunities. Primary energy sources should, therefore, trade for similar prices, correcting for BTU content and shipping costs. They rarely do. When pricing deviates substantially from this baseline assumption, the market is trying to tell us something.

For example, during the energy crisis of 2021-2022, both landed liquefied natural gas (LNG) and coal traded at substantial premiums to oil. Meanwhile, thermal coal traded for a premium to coking coal. Thermal coal had never traded for a premium to oil or coking coal before, at least as far back as our Bloomberg machine would let us plot. At that time, we speculated this was a signal that the market valued electricity more than chemicals and steel, and that Europe was headed for a period of stagflation. This turned out to be largely true.

Fast-forward to 2024 and the North American energy markets are currently experiencing perhaps the single greatest example of hydrocarbon arbitrage the world has ever seen, both in the size of the price differential and the huge volumes involved. We speak, of course, of the vast disparity between the price of domestic natural gas and that of oil. On an equivalent energy content basis, the price of a barrel of oil should be roughly six times that of a million BTUs of natural gas. Accounting for the complexity of handling natural gas, oil has historically oscillated between 10-20 times natural gas. As of the time of this writing, it stands at 45:

In our view, geopolitical risk explains this incredible disparity. Despite relatively balanced physical markets, the ongoing conflicts in Ukraine and the Middle East are pushing oil prices much higher than the rest of the primary energy complex. In meaningfully significant areas of the US, oil and gas are co-produced as complex mixtures. With oil trading where it is, the motivation to keep drilling is high, regardless of the price garnered for the unwanted gas byproduct. This is especially true in the Permian Basin, where spot prices for natural gas have been negative for much of the past month.

That which can’t go on forever usually doesn’t, and valuable hydrocarbons won’t trade for substantial discounts to their molecular peers indefinitely. Heat is heat, after all, and market forces will grind away at this staggering arbitrage until it is closed. Throughout North America, a quiet revolution is underway. Machines are being modified, processes reconfigured, and infrastructure developed to switch from expensive oil-based products to dirt-cheap gas. Let’s head to the shale patch and highlight a few interesting examples.


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