THE CAUSAL RELATIONSHIP IN NORTH AMERICAN ENERGY PRODUCTION.

Neil A Wilmot, University of Minnesota Duluth, 218-726-7439,

Ariuna Taivan, University of Minnesota Duluth, 218-726-8496;

Overview

It is widely known that the extraction of energy commodities in the U.S. has undergone a significant supply shock – the “shale revolution”. The manifestation of this shock in the production of natural gas has led to a complete reversal in the US LNG market. It was original expect that the United States would be an importer of LNG, while the dramatic increase in production has put the US on the verge of exporting LNG. As well, the previously observed decline in US oil production has been reversed with the exploitation of tight oil formations (Bakken, Eagle Ford, Niobrara). Thanks to the combination of hydraulic fracking and horizontal drilling, the cost of recovery from shale formations was significantly reduced. This has led to a flood of so-called “unconventional” oil and gas in the U.S. market, with implications for the relationship between crude oil and natural gas markets. According to Erdos (2012), the consequences of the shale gas boom was a disintegration of the relationship between US natural gas prices and oil prices. Yet, using European data (Brent, NBP) Asche et al (2012) find a long-term equilibrium between oil and gas prices, in a process disrupted by constant shocks. Furthermore, the authors argue what the consumer is ultimately seeking is energy, with the implication that a relationship between oil and gas, as substitutes, should exist in the long run.

The dramatic changes in U.S. production are likely to impact other regional producers; Canada in particular. In 2014, Canada was the 5th largest producer of crude oil worldwide, and the 5th largest producer of dry natural gas (EIA, 2015). The majority of Canadian oil and gas production is concentrated in the western provinces of Alberta and British Columbia. Of note, Alberta is home to the Oil Sands, which are considered higher cost production. According to Chapman (2014) a significant concern regarding the heavy oil of the Oil Sands is the low Energy Returns on Investment (EROI).Canada’s natural gas production from conventional sources has been on the decline, which has spurred interest and investment in unconventional sources. There are several shale gas formations at various stages of exploration and development. British Columbia has shown an increase in the production of unconventional gas, specifically targeting the Montney Formation. Yet Rivard et al(2014) points out that Canada is in the nascent stages of unconventional gas development when compared with the U.S. Herein, interest lies in understanding what, if any, impact the increasing U.S. production has had on Canadian production.

We examine this relationship using data on the production of the energy commodities in each country. In contrast, the literature examining the interconnectedness of the North American energy markets, typically utilizes the price mechanisms (Hartley et al, 2008; Brown and Yucel, 2008, 2009; Erdos, 2012; Wilmot, 2013, 2016]. Additionally, the period of study is dissected into two periods (pre- and post-2008), due to what would be described as a structural break, relating to increased shale production. (Brown and Yucel, 2013).

Methods

To examine the potential impact of US oil and natural gas production has on the production in Canada, we utilize several methods. The monthly production data, over the period 2000 – early 2015, is examined for nonstationarity using the Augmented Dickey-Fuller (ADF) tests. Based on the results of the ADF test, cointegrating methods are employed which allow for the determination of the cointegrating vector. The Johansen – Juselius cointegration test is examined, as well as Park’s Canonical Cointegrating Regression (CCR). Park’s CCR test reveals the presence of deterministic and stochastic cointegrating terms. The Vector Error Correction Model (VECM) is used to determine the short- and long-term relationships. To investigate the existence of Granger Causality, vector autoregression (VAR) methods are employed. The analysis was done over the entire sample, as well as the post 2008 period.

Results

The results of the ADF test indicate that crude oil and natural gas production, in the U.S. and Canada, are nonstationary. Based on the results of the VAR, the full sample results indicate bi-directional Granger Causality in both the crude oil and natural gas markets

Conclusions

The full sample results indicate that North America in a highly integrated energy market.Policymakers should consider how changes in the foreign market are going to impact the domestic economy. For example, the opening of energy export markets in the United States will directly impact Canadian energy markets. With a high concentration of oil and gas production in the western provinces, Canadian policy makers should be cognizant of the regional vulnerabilities due to this high concentration. In particular, employment effects and royalty shocks have the potential to significantly impact economic performance in these provinces.

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