...years, natural gas prices have been on an upward trend with crude oil prices but with considerable independent movement. Natural gas market analysts generally emphasize weather and inventories as drivers of natural gas prices. Using an error-correction model, we show that when these and other additional factors are taken into account, movements in crude oil prices have a prominent role in shaping natural gas prices. Our findings imply a continuum of prices at which natural gas and petroleum products are substitutes.

1. INTRODUCTION

For many years, natural gas and refined petroleum products were seen as close substitutes in U.S. industry and electric power generation. Industry and electric power generators switched back and forth between natural gas and residual fuel oil, using whichever energy source was less expensive. Consequently, U.S. natural gas price movements generally tracked those of crude oil. As shown by Yucel and Guo (1994), crude oil prices were shaped by world oil market conditions, and U.S. natural gas prices adjusted to oil prices.

Over the past 15 years, however, the number of facilities able to switch quickly between natural gas and refined petroleum products has declined. Although U.S. natural gas prices have taken a general upward trend with crude oil prices over the past seven years, they also have shown considerable independent movement. Natural gas prices rose above what was seen as their historical relationship with crude oil prices in 2000, 2002, 2003, 2004 and late 2005. In 2006 and the first half of 2007, natural gas prices seemed to fall well below this historical relationship. In apparent confirmation of these observations, Bachmeier and Griffin (2006) find only a weak relationship between oil and U.S. natural gas prices. In contrast, a more recent study by Villar and Joutz (2006) finds oil and natural gas prices to be cointegrated with a trend. In related work, Asche, Osmundsen and Sandsmark (2006) find cointegration between natural gas and crude oil prices in the U.K. market after natural gas deregulation, and crude oil prices leading those for natural gas.

In a slightly different vein, Hartley, Medlock and Rosthal (2007) find that substitution between residual fuel oil and natural gas is particularly strong in the U.S. North American Electric Reliability Council (NERC) regions where there is sufficient fuel-switching capability. They also find limited substitutability between natural gas and heating oil for space heating and between the use of gas-fired and distillate-fired peaking plants for the generation of electricity. Because natural gas and crude oil price do not move in perfect synchronization, these findings suggest a continuum of substitution opportunities, with the price of natural gas being set by a marginal user, and that user being determined by the relative prices of oil and natural gas.

None of the previous analyses of the relationship between natural gas and crude oil prices take into account factors other than oil prices that might influence natural gas prices, but those who watch natural gas markets emphasize the effects of other factors--such as weather, inventories, and shut in production. Our analysis reveals that crude oil and natural gas prices still have a powerful relationship, but the relationship is conditioned by weather, seasonality, natural gas storage, and shut in production in the Gulf of Mexico. When these additional factors are taken into account, movements in natural gas prices are well explained by crude oil prices.

2. THE RELATIONSHIP BETWEEN OIL AND NATURAL GAS PRICES

Given the historical importance of substitution between natural gas and petroleum products, the energy industry has long used rules of thumb to relate natural gas prices to those for crude oil. Two simple rules of thumb use constant ratios between natural gas and crude oil prices. One seems to fit historical data, and one roughly reflects the difference in energy content between the commonly sold units of oil and natural gas. Other rules of thumb try to relate parity in the pricing of natural gas to residual fuel or distillate fuel oil at the burner tip and trace back the implications for natural gas and crude oil prices at major trading hubs.

We treat the Henry Hub price of natural gas as generally representing overall market conditions for natural gas in the United States, and use it in evaluating the relationship between crude oil and natural gas prices. Henry Hub, near New Orleans, handles the highest volume of natural gas of any U.S. transportation node and is close to the largest concentration of natural gas producing regions in the country. Although the physical links between Henry Hub and Eastern markets are more prominent than those between Henry Hub and other regional markets, numerous studies show that the U.S. natural gas market has been generally integrated by open access and other regulatory changes. De Vany and Walls (1993, 1994), Doane and Spulber (1994), and MacAvoy (2000) all find U.S. natural gas markets to have been progressively integrated and that the "US market for gas has evolved into a competitive market for a homogeneous commodity." (1) Serletis and Herbert (1999) add that the Henry Hub spot price is strongly correlated with the NYMEX futures price, which is the most widely traded natural gas contract in the world.

2.1 Simple Rules of Thumb

One simple rule of thumb is...

NOTE: All illustrations and photos have been removed from this article.



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