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The relationship of natural gas to oil prices.

Article Excerpt
We investigate the relationship between the prices of natural gas and crude oil, and the factors that cause short run departures from the long run equilibrium price relationship. We find evidence that the link between natural gas and crude oil prices is indirect, acting through competition at the margin between natural gas and residual fuel oil. We also find that technology is critical to the long run relationship between fuel prices, and short run departures from long run equilibrium are influenced by product inventories, weather, other seasonal factors and supply shocks such as hurricanes.

1. INTRODUCTION

The relationship between natural gas and crude oil prices affects both energy consumers and providers, especially by influencing their incentives to invest in inventories or different types of energy using equipment. Energy market traders also are interested to know whether there is a tendency for the relative prices of different energy commodities to return to a particular value, since if such a tendency exists it might form the basis of a trading strategy. A historical "rule-of-thumb" of a ratio of WTI to the Henry Hub of 10:1, so that natural gas priced at one-tenth the price of a barrel of crude oil, seemed to disintegrate during the late 1990s and early 2000s, evolving to something closer to 6:1. Variability in the relative price relationship, which has in fact ranged from 4:1 to 12:1, has prompted questions as to whether or not the prices of natural gas and crude oil have decoupled, or if there is a stable relationship at all.

In this paper, we use monthly data from February 1990 through October 2006 to demonstrate the existence of a long run cointegrating relationship between the residual fuel oil price, the natural gas price and technological change in electricity generation. We thus provide a technological explanation for the apparent change in the relationship between crude oil and natural gas prices in recent years. By estimating a vector error correction model (VECM) that includes some stationary exogenous variables, we also identify shocks that cause departures from that relationship. The VECM also allows us to identify a causal ordering in price adjustment, and how fast that adjustment occurs.

We begin from the premise that electricity generation plays a key role in influencing the relative prices of different energy commodities. In a recent paper, Hartley, Medlock and Rosthal (2007) show that substitution between natural gas and residual fuel oil is particularly strong in a few regions in the United States where there is sufficient system-wide switching capability. (1) Even in regions where individual plants cannot switch between fuels, different types of plant can be operated for different lengths of time as fuel prices change, extending the switching capability of the system.

Plant and grid level switching between different fuel types by electricity generators imposes strong pressure to limit deviations in the relative prices of competing fuels. Specifically, when possible, generators will arbitrage the cost of producing electricity in dollars per megawatt hour ($/MWh), which equals the price of fuel in $/Btu times the heat rate in Btu/MWh. Hence, changes in the heat rates of the plants using the different fuels will change their relative competitiveness. We therefore argue that the development of combined cycle gas turbines (CCGT) has raised the attractiveness of natural gas as a fuel for generating electricity. The resulting demand-side pressure, in turn, has contributed to an increase in the price of natural gas relative to fuel oil and hence also to crude.

2. PREVIOUS RESEARCH

Other authors have considered the cointegration of various energy prices. Of particular interest to us are papers that examine the cointegration of prices of different commodities. (2) One paper in particular considered the relationship between natural gas and residual fuel oil prices. Serletis and Herbert (1999) test for the existence of common trends in daily natural gas prices at Henry Hub and Transco Zone 6, the price of power in PJM, and the price of residual fuel oil at New York Harbor from October 1996 through November 1997. They find that the three fuel prices are cointegrated and that Transco Zone 6 prices adjust significantly faster than do Henry Hub prices to deviations in their long run relationship. Serletis and Herbert also find that fuel oil prices show no significant adjustment to deviations in the long run relationship with either Henry Hub or Transco Zone 6 natural gas prices. However, the Transco Zone 6 natural gas price does appear to adjust to movements in the fuel oil price at New York Harbor, indicating regional competition between the two fuels. Their results thus support weak exogeneity of fuel oil prices in the system of equations. Similarly, the fact that the Transco Zone 6 price adjusts most quickly to both long run price relationships suggests that it is in a sense the "most endogenous" price of the three, a result that is not surprising given that Transco Zone 6 reflects a local end-of-pipe market.

Building on this analysis, Serletis and Rangel-Ruiz (2002) examine the existence of common price cycles in North America energy commodities using the daily prices of natural gas at the Henry Hub and WTI from 1991 through 2001. In addition, they studied cointegration of U.S. and Canadian natural gas prices. They concluded that natural gas prices at Henry Hub and AECO (a liquid pricing point in Alberta) demonstrate common cycles, but Henry Hub and WTI do not have common price cycles. They claim this decoupling of U.S. energy prices is a result of deregulation.

Villar and Joutz (2006) examine the apparent decoupling of the prices of WTI crude oil and Henry Hub natural gas in more detail, finding a cointegrating relationship between the two prices that exhibits a positive time trend. This indicates that the prices have a long run relationship that is slowly evolving rather than constant. Villar and Joutz estimate an error correction model that includes exogenous variables such as natural gas storage levels, seasonal dummy variables, and dummy variables for a few other transitory shocks. Their analysis supports the findings of Serletis and Rangel-Ruiz (2002) that the price of WTI is weakly exogenous to the price of natural gas at the Henry Hub.

Brown and Yucel (2007) used an ECM to analyze weekly prices from January 1994 through July 2006. They found that the price series are cointegrated over this period, indicating a stable long run relationship. (3) They found that short run deviations from the estimated long run relationship could be explained by market fundamentals such as storage levels, weather, and the quantity of production shut-in due to hurricanes. They report that the price of natural gas at Henry Hub responds significantly to the deviation from the long run relationship, changes in the prices of natural gas for the preceding two weeks, and the change in the price of oil one week earlier. Furthermore, they report that weather and storage levels both have significant effects on the price of natural gas by moving it temporarily away from the long run relationship to crude oil prices. Similar to previous studies, Brown and Yucel found the direction of causality is from the price of WTI to the price of natural gas at Henry Hub, but not the other direction.

Bachmeier and Griffin (2006) also examine the evidence for cointegration within as well as...

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