HAVE OIL AND NATURAL GAS PRICES DECOUPLED?

Stephen P.A. Brown, University of Nevada, Las Vegas, 702-895-3191,

Mine Yucel, Federal Reserve Bank of Dallas, 214-922-5160,

Overview

For many years, fuel switching between natural gas and residual fuel oil kept natural gas prices closely aligned with those for crude oil. More recently, however, the number of U.S. facilities able to switch between natural gas and residual fuel oil has declined. Moreover, the shale revolution has dramatically increased the supply of natural gas in the United States. For the short-term, natural gas market analysts generally emphasize weather and inventories as drivers of natural gas prices. We first test to see whether the long-term relationshipbetween oil and gas has changed in recent years. We find that the relationship changed in 2009. The combination of horizontal drilling and hydraulic fracturing (aka fracking) has dramatically increased the supply of natural gas in the United States, and that has contributed to a changed relationshipbetween natural gas and oil prices after 2009.

Methods

We examine the relationship between weekly crude oiland natural gas prices from 1997 to 2012. In addition to price data, we utilize heating and cooling degree days,natural gas storage, shut-in production in the Gulf of Mexico and natural gas production data. We check for stationarity of all series and find that our price data are integrated of order one. Other data are I(0). We first test for breakpoints in the relationship between oil and natural gas prices. We then check for cointegration in the full sample and in the two sub-samples. Making use of information about the breakpoints and the data in its stationary form, we run a reduced-form model in which we test for changes in the relationship between oil and natural gas prices.

Results

We ran stationarity tests and found both price series to be integrated of order one. Other data are I(0). We tested for and found a break-point in the relationship between natural gas and oil prices in February 2009. We then tested for cointegration in the full sample and the two subsamples. We found that oil and natural gas prices were cointegrated in the two subsamples but not over the full sample.

Making use of the cointegrating relationships as appropriate, we run a modified Granger-causality model for the whole sample and each of the two subperiods with lags of differenced natural gas and oil prices, andan instrumented natural gas production variable. We also include heating degree days, deviations from normal heating degree days, cooling degree days, deviations from normal cooling degree days, shut-in production, and a natural gas storage differential as stationary exogenous variables affecting the short-term dynamics of natural gas prices.The storage differential is calculated as the difference between the storage in a given week and the average for that week over the past five years. Shut-in production in the Gulf of Mexico is a series assembled from individual reports made by the Minerals Management Service of the U.S. Department of Interior.

Preliminary analysis finds the relationship between natural gas and oil prices shifts downward in 2009, but that oil prices still affect natural gas prices in the later subperiod. The effects of the exogenous stationary variables appear to remain the same across the two subperiods. These results need to be considered preliminary, as we are still refining the econometric work in the paper.

Conclusions

Our preliminary results lead us to conclude that the surge in natural gas supply has dramatically changed the relationship between oil and natural gas prices. Nonetheless, we still find that movements in oil prices influence the movements in natural gas prices. Other variables--such as weather, seasonality, natural gas in storage and disruptions of natural gas production in the Gulf of Mexico--seem to have the same effects on natural gas prices that they did in the past.

References

Bachmeir, Lance J. and James M. Griffin (2006), “Testing for Market Integration: Crude Oil, Coal and Natural Gas,” The Energy Journal 27(2): 55-71.

Brown, S.P.A. and Mine Yucel (2008). “What Drive Natural Gas Prices?”, Energy Journal, 29 (2): 45- 60.

Hartley, Peter, Kenneth Medlock and Jennifer Rosthal (2008). “The Relationship Between Crude Oil and Natural Gas Prices.” Energy Journal 29 (3): 47-65. .

Parsons, John and David Ramberg (2011). “The Weak Tie Between Natural Gas and Oil Prices.” Energy Journal.

Villar, Jose and Joutz, Fred (2006), “The Relationship Between Crude Oil and Natural Gas Prices,” EIA manuscript, (October).