Watch Oil Prices Drop as China Focuses on Natural Gas

NEW YORK ( TheStreet) -- As the top two populated countries in the world, China and India are often included in any debate about the future of energy prices. The growth rates experienced in both economies have astounded the world while stretching natural resources thin.

The Middle Kingdom's appetite for oil and natural gas has led China on a commodity search through Africa and the Middle East. China has not found difficulties securing large sources of all the commodities needed to keep its economy humming along smoothly.

Securing China's energy needs is no easy challenge. At one time, China's domestic supply of natural gas provided enough output to meet demand. For the last few years, however, China has imported natural gas right along with oil.

China's natural gas consumption remained relatively stable from 1980 until 1992 near 500 billion cubic feet per year. After Deng Xiaoping took control of China and directed parts of China to allow free-market enterprises, growth in GDP and energy consumption moved higher. By 2004, consumption of natural gas more than doubled to about 1300 billion cubic feet. In the last year data is available, consumption reached 3.768 trillion cubic feet.

China's natural gas production largely kept up with demand, an amazing feat in light of the difficulties faced with increasing production by almost seven fold from 1996 to 2010. Production for 2010 was 3.334 trillion cubic feet.

Because demand is greater than production, China now imports natural gas to meet demand. Oil demand and production largely mimic natural gas leaving China a net importer of petroleum also. China imported about three million barrels a day in 2011.

The United States, also an importer of oil, has recently updated the amount of proven oil and natural gas as a result of new extraction method technology. A method known as hydraulic fracturing, or "fracking," allows greater amounts of oil and natural gas production in areas that until recently were out of reach.

Fracking is a game-changer for energy production. As a result, the U.S. has the greatest amount of proven natural gas reserves in the world, even greater than Saudi Arabia...

Oh wait, slow down. Wrong. Now China has the greatest amount of proven natural gas reserves in the world. China currently has about 107 trillion cubic feet available.

China has made it abundantly clear it wants its natural gas out of the ground and moved to consumers as fast as possible. A country that demonstrated the ability to grow sevenfold within 14 years is capable of extraordinary achievements.

China is under pressure to switch from oil to less expensive natural gas. Not only is natural gas cheaper than oil but, because of long-term contracts signed with Turkmenistan and the slowing of the economy, China has slowed production out of currently producing wells. The contracts for natural gas include pay or take clauses, and not enough storage capacity to store excess. To maintain a balance, currently producing wells are adjusted for output.

The current excess total supply of natural gas may leave one wondering why China is committing billions of dollars towards expanding domestic natural gas supplies. Granted, economic growth should sooner or later equalize demand with supply and eventually overcome it, but that doesn't explain all of it.

Clearly China wants to displace oil imports for domestically produced natural gas and in a big way. Probably the fastest way to move from oil to natural gas is already known. Replacing gas and diesel engines with natural gas engines is relatively easy. Natural gas pollutes less, and cost less for vehicles to operate.

One look at United States Oil ETF USO ( USO) and U.S. Natural Gas ETF UNG ( UNG) demonstrates the impact on energy prices in America. S&P Energy Select ETF XLE ( XLE) represents energy producers and recently moved off of lows. (Read my Get Ready For $65 (or Lower) Oil article.)

Natural gas prices went into a free-fall after fracking became available in Pennsylvania and other nearby states. Now natural gas prices are well under $3 per million BTUs. The low natural gas prices, normally influenced by oil prices have decoupled.

China is paying over $10 per million importing, but it's reasonable to assume a price of under $5 is achievable once the logistics have enabled production to reach consumers.

Two major changes in China's energy needs will happen as production moves higher. The first is the mitigation and likely end of oil imports into China, removing massive demand in the oil markets.

The second significant change is the production of vehicles. As domestic natural gas supplies increasingly come online, expect vehicles to either drive out of the factory able to use dual fuel (gas/diesel or natural gas), or simply natural gas.

Both Ford Motor ( F) and General Motors ( GM) produce natural gas vehicles and have factories in China. Ford recently committed to expanding their presence in Asia and China. (Read my Get Ready To Accelerate Your Ford Investment article.)

Financially, it makes perfect sense for Ford and GM to produce natural gas vehicles in both markets. China is the largest auto market in the world and the U.S. is the second largest. Both countries drive on the "right" side of the road although I believe the safety standards are different. The salient point is the total market for natural gas cars is more than needed to justify the research and development investment for both Ford and GM.

When the two largest oil-consuming nations in the world rotate out of oil and into natural gas, expect oil price headwinds. Also, expect a higher floor in the price of natural gas. Both countries will continue to use oil but the amount imported is almost assured to fall. (Read my EU's Iran Sanctions More Bark Than Bite article.)

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
At the time of publication the author did not hold a position in any stock mentioned.

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