Oil market may be tighter than thought

European natural gas customers have a strong incentive to switch to oil

Oil & gas markets are not only global but also complex. Natural gas and oil can both produce energy and the ratio is about 6.1 Mcf of natural gas produces about the same heating value as 1 barrel of oil. This ratio is often used as a “barrel of oil equivalent” despite its limitations in that some gas has heat content that differs from the average as does some grades of oil, but it is close enough for government work as the saying goes.

In Europe, natural gas prices reflect ill-conceived government policies and the disruption of the Ukraine war which have combined to produce prices similar to the UK NBP price of US$36.40 per thousand cubic feet. Japan suffers even higher prices at US$38.66 per thousand cubic feet.

Using the 6.1 to one ratio, UK natural gas is priced on a heat content (measured in British Thermal Units or BTU’s) equivalent to US$222 per barrel of oil and in Japan the equivalent oil price would be US$236 per barrel. Obviously, if it is possible to switch boilers from natural gas to oil for electricity generation, operators could cut their fuel costs more or less in half.

Coal is also an alternative for many power generators. Thermal coal today is prices about US$370 per tonne and each tonne produces about 25 million BTU of heat¹ so the cost per million BTU using coal is somewhere around US$15 or, expressed as oil equivalent, about US$90 a barrel. Coal is cheaper than oil for power generation in United States where natural gas has the edge, but in Europe or Japan coal and oil are in the same ballpark and natural gas is at nosebleed levels. Something has to give.

Unfortunately, switching fuel sources is not easy for coal fired generating plants designed for coal and even if gas were available and could be used, there is an efficiency penalty (Some plants are designed for both). Nonetheless, such conversions are becoming more commonplace and the barriers are less than popularly thought. Where operators have a fleet of both gas and coal fired plants and capacity is greater than demand, they can switch readily, but generating companies don’t typically have such fleets. If the economic incentive is large enough, new plants can be built and the application of enough capital over time can alter the mix of fuels.

In Pakistan, much power is produced from oil fired generating plants and there has been some effort to convert some of them to coal, once again at a capital cost. Pakistan depends on imported LNG and is desperate to find an alternative given the very high cost of LNG.

Generally, natural gas and coal have been cheaper power sources than oil worldwide, but obviously that is no longer the case in Europe or the U.K. In America, 13% of U.S. power generators have the ability to switch between natural gas and oil according to Energy Information Administration (EIA) data. It seems the Europeans were not as far sighted in building their power infrastructure.

In Europe, the economic benefit of a switch to oil from natural gas is material, and the International Energy Agency (IEA) is promoting that switch as a means to reduce reliance on Russian natural gas.

The impact on global oil demand of such a switch would be significant. About 30% of Europe’s natural gas usage is for power generation - about 15 Bcf/day or the equivalent of 2.5 million barrels of oil a day. With the urgent need to find enough energy and to displace Russian natural gas, Europe and the United Kingdom have both an economic and geopolitical motive to switch from natural gas to oil and I expect they will try do so over the next few years. Adding a million or two barrels a day to world oil demand will make oil markets even tighter than they are today.

Unless the Biden administration encourages a sharp rise in both U.S. oil and U.S. natural gas production, the energy problem faced by the U.K and Europe is dire and getting worse. In the meantime, as the geopolitical pressures collide with the inane climate change rhetoric, energy investors should benefit.

Vermillion Energy (VET.TO) is reasonable way to benefit from the very high natural gas prices in Europe. All North American oil producers will benefit from the tighter oil markets that may result from a switch to oil-fired from gas-fired generation in Europe and Japan, if that happens on any scale.

1. Varies by grade of coal