With oil prices on the rise, oil stocks are one of the sectors that have held up during the downturn.  Yet shares of the major oil companies have not kept up with the rising price of crude.

The basic rationale is that “oil prices are going up, so shares of oil companies will naturally follow.” It’s a pretty simple theory that has worked in the past. And I understand it makes sense on paper. But in practice it just hasn’t paid off too well recently.

Since November 2007, when oil was trading for around $85 a barrel, the oil industry heavyweights including Exxon Mobil (XOM), Chevron (CVX) and BP (BP) have actually declined 8% on average. Meanwhile, oil prices have added another 25-30%.

Oil Up, Oil Stocks… Down?

What’s the deal, you ask? Well, the answer is pretty simple. With oil prices at all-time highs, consumers have turned to alternative sources of energy.

I’m not talking about the economically questionable sources like ethanol, biofuels and the related “green” industries that always have their hand out for the next round of politically motivated subsidies. Nope, not at all. I’m talking about the true alternative to oil: natural gas.

Let’s face it; it’s going to be years before true non-fossil-fuel-based alternative energies will be economically self-sustaining. So instead, we’ve got to look at a here-and-now alternative to oil that is economical, proven and ready to go. That’s where natural gas fits in perfectly.

Energy Economics 101

Oil is used for all sorts of things, not just gasoline and diesel production. The United States consumes quite a bit of oil in electrical power plants. In fact, 45% of the nation’s electricity plants have the capability of being oil-fired. However, the vast majority of those, more than 90%, are considered “multifuel” power plants.

A multifuel power plant burns natural gas or oil to produce electricity. Basically, a multifuel power plant can switch from burning oil to natural gas and back again without any major retooling. The switch can be done more or less at the flick of a switch.

That’s why high oil prices are a boon for natural gas prices. It all comes down to the “energy value” of each. The energy value of these resources is how much energy can be produced from burning them.

When related to the cost of both natural gas and oil, $100 buys you about 5 million BTUs worth of oil. Meanwhile, $100 will buy you about 10 million BTUs worth of natural gas.

In relative energy value terms, oil is about twice as expensive as natural gas.

The last time we saw oil reach twice the relative energy value of natural gas was in 1990. That year marked the start of an eight-year bull for natural gas. In 1998, natural gas hit its peak when it was worth 10% more than oil in relative energy terms.

The cause of the long-term shift in relative values of natural gas and oil was caused by power plants. And with the energy values of oil and natural gas so out of whack right now, just like back in 1990, these multifuel power plants are going to be making the shift away from oil into natural gas. As a result, demand for natural gas has to rise.

Oil is not going anywhere for the time being, though. Realistically, oil has some properties that make it a more viable energy source than natural gas. Of primary importance is that oil is a liquid. Since oil is a liquid, it can easily and safely (relatively speaking, of course) be transported all around the world.

As for natural gas, if you’re not near a natural gas pipeline or well, then LNG (liquefied natural gas) is the only way to ship it. Natural gas can be compressed into a liquid, but it requires specialized liquefaction facilities that cost around $5 billion minimum and take years to construct. Then special ships are needed to transport the LNG.

Don’t get me wrong; LNG is the wave of the future, and you’ll be learning about how to profit from it soon. But we’re still building infrastructure for it.

It’s All Relative

With the relative energy value of oil and natural gas so far out of whack, it’s only a matter of time until natural gas goes sky-high. If oil hits $150, natural gas could easily triple from current levels and still be economically viable.

That’s the potential upside here, and that’s why I’d recommend putting your energy-focused investment dollars toward natural gas. While oil has a lot of merit, natural gas has a lot more upside potential with potentially less downside risk.

The simple economics of it all point squarely in favor of natural gas.