somrh (90.42)

Predicting Oil and Natural Gas Returns

August 16, 2012 – Comments (0) | RELATED TICKERS: USO , UNG

In a couple of previous blogs I looked at the relationship between CPI and commodities and using that information to predict future real returns of those commodities. First I looked at CPI/Gold and then looked at CPI/Silver and CPI/Platinum.

Today we'll look at a couple of energy commodities: oil and natural gas. To summarize again, the general model is given by:

Real Returns = A x CPI / Commodity - B, where A/B is the "breakeven" (in real terms) commodity/CPI ratio. 

We'll start by looking at oil:

So far it looks like the same story. The model fits fairly decently (though still not as good as gold.) It's predicting negative returns, which is consistent with negative TIPS rates that are currently present. 

What about natural gas?

Natural gas is quite cheap right now due to excess supply here in the states. The model is currently predicting high real returns. The correlation between CPI/NG and real returns is not as strong as the other commodities. In any event, it is predicting real returns much higher than one can obtain from alternative assets.

The interesting question is whether this relationship will hold in the future. I'm inclined to say that it will not; I suspect returns might be higher than the model is projecting. Ultimately there is a finite amount of oil and gas reserves and the world's energy needs continue to be substantial. Unless we better utilize alternative energy, supply of these resources will continue to decline and may drive up prices in the future.