The Weak Tie Between Natural Gas and Oil Prices 30 th 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 Presentation to 30th USAEE/IAEE North American Conference, October 12, Do not reproduce. 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 Presentation to 30th USAEE/IAEE North American Conference, October 12, Do not reproduce. Natural Gas and Crude Oil Spot Prices, (real 2010 dollars)

4 Presentation to 30th USAEE/IAEE North American Conference, October 12, Do not reproduce. Is the Relationship Stable over Time, or has it Shifted?

5 Presentation to 30th USAEE/IAEE North American Conference, October 12, Do not reproduce. Is the Relationship Stable over Time, or has it Shifted?

6 Presentation to 30th USAEE/IAEE North American Conference, October 12, Do not reproduce. Methods to Test De-coupling Possibilities Revisit Cointegrating Relationship: P HH,t = γ + βP WTI,t + μ t ( logP WTI,t + μ t ) P-Value of cointegrating relationship: 0.001, R 2 of full model: 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: logP HH,t = logP WTI,t + μ t  P-Value of cointegrating relationship: , R 2 of full model: Apply VECM/Conditional ECM methodology from March 2006 to identified breakpoint February 2009: logP HH,t = logP WTI,t + μ t  P-Value of cointegrating relationship: , R 2 of full model:  No cointegrating relationship identified between February 2009 and December 2010

7 Presentation to 30th USAEE/IAEE North American Conference, October 12, Do not reproduce. Graphing Two Cointegrated Periods Against Actual Henry Hub Prices

8 Presentation to 30th USAEE/IAEE North American Conference, October 12, Do not reproduce. 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.

The End Questions?

Additional Slides

11 Presentation to 30th USAEE/IAEE North American Conference, October 12, Do not reproduce. The Mathematics Behind VECM and Conditional ECM Cointegration Models Vector Error Correction Model (VECM): Conditional Error Correction Model (conditional ECM):

12 Presentation to 30th USAEE/IAEE North American Conference, October 12, Do not reproduce. 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:  logP HH,t = γ + β logP WTI,t + μ t  = logP WTI,t + μ t Cointegrating relationship has smaller in-sample errors than any of the rules of thumb

13 Presentation to 30th USAEE/IAEE North American Conference, October 12, Do not reproduce. Graphing Two Cointegrated Periods Against Actual Henry Hub Prices