Oil vs. natural gas

The historical trade-off between the price of oil and natural gas has been 6 to 1, meaning if oil sold for $30 per barrel and natural gas for $5 per mmcf, the two commodities would be equally priced on a BTU basis.

Therefore, a natural substitution effect occurs. When oil is greater than six times the price of natural gas, it would be cheaper for consumers of energy to substitute gas for oil. Conversely, if oil were less the six times the price of natural gas, it would be cheaper to use oil and switch away from using gas. This substitution effect pretty much kept this ratio in tact.

However, in today's market, with oil at $82 per barrel and natural gas selling for $6.00 per mmcf, that ratio has expanded to 13.6x (!). That's huge. This means consumers of energy should be switching all their energy consumption away from oil to natural gas.

How should investors play this? One way is to short oil and go long natural gas. However, that could prove to be a risky strategy. Another way is to look at merchant power producers that use natural gas. Two plays are The AES Corporation (NYSE: AES) and Dynegy Inc (NYSE: DYN). Both use a good amount of gas to produce power and both have corrected rather meaningfully during this market downturn and represent good value.