The Weak Tie Between Natural Gas and Oil Prices

1. The Weak Tie Between Natural Gas and Oil Prices 30th USAEE/IAEE North American Conference October 12, 2011 David Ramberg, MIT Engineering Systems Division (Co-author and Committee Member: John E. Parsons Committee Chair: Mort D. Webster)

2. The Relationship Between Crude Oil and Natural Gas Prices • Historically, observers have noted price relationship between crude oil and natural gas. • Rules of Thumb • 10-to-1 • Energy Content Equivalence (≈ 6-to-1) • Distillate Fuel Oil Burner-Tip Parity • Residual Fuel Oil Burner-Tip Parity • Cointegration (Villar and Joutz, 2006, Brown and Yücel, 2008, Hartley, Medlock, and Rosthal, 2008) • Recent discussion about “decoupling”: • Temporary break from usual relationship (return later) • Permanent break from old relationship and move to new one • No longer any relationship at all • Which is it?

3. Natural Gas and Crude Oil Spot Prices, 1991-2010 (real 2010 dollars)

4. Is the Relationship Stable over Time, or has it Shifted?

5. Is the Relationship Stable over Time, or has it Shifted?

6. Methods to Test De-coupling Possibilities • Revisit Cointegrating Relationship: PHH,t = γ + βPWTI,t + μt(-0.0333 + 0.468logPWTI,t + μt) • P-Value of cointegrating relationship: 0.001, R2 of full model: 0.1479 • Conduct Gregory and Hansen (1996) tests using above functional form and iteratively test for breakpoints at each observation. • Apply VECM/Conditional ECM methodology from June 1997 to identified breakpoint March 2006: logPHH,t = -1.2007 + 0.7261 logPWTI,t + μt • P-Value of cointegrating relationship: 0.0000, R2 of full model: 0.2094 • Apply VECM/Conditional ECM methodology from March 2006 to identified breakpoint February 2009: logPHH,t = 0.1969 + 0.4621 logPWTI,t + μt • P-Value of cointegrating relationship: 0.0000, R2 of full model: 0.2603 • No cointegrating relationship identified between February 2009 and December 2010

7. Graphing Two Cointegrated Periods Against Actual Henry Hub Prices

8. Conclusions • Crude oil and natural gas prices in the U.S. tend to be cointegrated in the long-run, but: • Volatility in natural gas prices much higher than crude oil prices. Frequent deviations from long-run relationship • Relationships gradually shifting as new technologies and policies that govern interaction between fuels, demographic, and other demand-side factors develop • Models themselves only generally accurate at relating natural gas price levels vis-à-vis crude oil prices. • Post-February 2009 period likely indicative of relationship in flux rather than permanent severance of crude oil-natural gas pricing relationship. • Due to shortage of data points to uncover a subtle relationship/lack of much price variation, and • Likely because of advent of economic methods for shale gas extraction coming online. • New equilibrium will likely develop over time.

9. The End Questions?

10. Additional Slides

11. The Mathematics Behind VECM and Conditional ECM Cointegration Models Vector Error Correction Model (VECM): Conditional Error Correction Model (conditional ECM):

12. Methods to Test De-coupling Possibilities • Test for a co-integrating relationship: • Search for a combination of the two variables of a specified functional form that is stationary over time. • After accounting for short-run divergence from this long-term relationship and subsequent readjustment back to the long-term relationship, the remaining errors are stationary. • Persistent result is that US natural gas & oil prices have been cointegrated. • Data on seasonal, weather, and supply-related variables unavailable before June 1997 • Basic cointegrating relationship from June 1997 – December 2010: • logPHH,t = γ + β logPWTI,t + μt • = -0.0333 + 0.468logPWTI,t + μt • Cointegrating relationship has smaller in-sample errors than any of the rules of thumb

13. Graphing Two Cointegrated Periods Against Actual Henry Hub Prices