From the OPEC-led production cuts to global geopolitical turmoil to surging demand in China, a variety of factors have been pushing oil prices to four-year highs.  U.S. WTI has recently been up 20% this year to over $71 per barrel, and the possibility of $100 oil has entered the market.

Although not immediately recognizable, the impact on natural gas is significant.  The oil and gas extraction business is as integrated as ever.  As the U.S. shale revolution has continued to soar since 2008, the traditional oil giants such as ExxonMobil, Shell and BP have become increasingly more involved in producing natural gas, viewed as the go-to fuel in installing a less carbon-intensive energy system.

Historically, this wasn’t the case as the vast majority of U.S. natural gas was produced by smaller independent companies that only produced natural gas.  So rising oil prices today, compared to years past, are increasing the earnings for more of our key gas producers, which will trickle down and potentially allow additional capital spending on gas production.

Oil and gas prices today almost have an inverse relationship, in large part thanks to the Permian shale play in West Texas, which is the largest U.S. oil field (3.3 million b/d) and the second largest gas field (10.3 Bcf/d).  The Permian is an associated gas play where gas comes along as essentially a ‘free” byproduct of crude oil production.  Despite rising infrastructure constraints, the Permian is expected to nearly double its gas output by 2025.  

For demand, it’s important to note that oil and gas are not the substitutable products for each other that they once were.  That’s because they now mostly compete in different markets, indicating that rising or falling prices of one can’t significantly impact demand of the other.  For example, power generation accounts for 35% of total U.S. gas usage, when it’s only 1% of U.S. oil demand.  Transportation, meanwhile, accounts for 70% of U.S. oil consumption versus less than 1% for gas.

Come winter, if oil prices remain elevated, we could see some gas displacing oil in heating, but oil as a heating fuel is fading even in the only region where it has remained relevant: the Northeast.  Manufacturing (industrial use), however, is one area where rising oil prices encourage substitution to natural gas.  Used as a feedstock to make plastics, higher cost naphtha from oil can be displaced by lower cost ethane from natural gas.  This substitution though isn’t large enough to significantly impact prices.

But increasingly going forward, the primary way that higher cost oil encourages U.S. gas demand is via liquefied natural gas (LNG) exports around the globe.  Rising oil prices increase prices for the bulk of the world’s LNG, a rapidly growing business where prices are largely linked to crude oil prices.  The U.S. is a burgeoning global LNG superpower and uniquely and attractively sells its LNG with a price linked to domestic Henry Hub gas prices – more transparently contingent on supply and demand factors.  

In other words, higher oil prices increase the competitiveness of U.S. LNG and can expand U.S. demand by supporting exports.  Although today U.S. cargoes abroad are limited by having just two LNG export terminals, the country could have seven such facilities online within three years.  Therefore, given that most of U.S. competition still seeks oil-indexed pricing for LNG, higher oil prices could become a significant price driver of domestic U.S. gas prices by encouraging supplies to leave the country.  

To be clear, oil is an international commodity and is impacted by global geopolitical events, whereas natural gas still stands as a regional commodity mostly shielded from outside influences.  Only about 30% of the world’s gas is internationally traded because it expensively needs to be liquefied first, versus 70% for oil.  The rapidly booming LNG trade, however, is gradually establishing a global market where gas sells like oil.  And the more active the U.S. becomes in this business, the more outside forces can impact domestic gas pricing.