1 International Market Integration for Natural Gas? A Co-integration Analysis of Gas Prices in Europe, North America, and Japan Guillaume L'Hégaret, Boriss Siliverstovs Christian von Hirschhausen, Anne Neumann DIW Berlin 6 th IAEE European Conference Zurich, September 2004

2 Agenda 1. The Issue: Internationalization of Natural Gas Markets 2. Theory and Data 3. Model 1: Cointegration of International Gas Prices 4. Model 2: Convergence of Trans-Atlantic Gas Prices 5. Conclusions

3 1. The Issue: Increasing Integration of Natural Gas Markets - At the European level: -EU-Acceleration Directive 2003/55: increasing competition within and between countries -Decreasing weight of oil price indexation, e.g. long-term gas contracts in the UK - At the international level: -Trend towards LNG in the three large gas consuming regions (North America, Europe, Asia) -Internationalization of LNG markets, in particular: - Intensification of transatlantic LNG-trade and... competition => This presentation analyzes the relation between international marker prices for gas and oil, with a view of quantifying long-term links between them => Our working hypothesis is that the split between the European and the North American gas markets did prevail in the 1990s, but that one might increasingly see signs of market integration

4 Net Inter-Regional Natural Gas Trade Flow, 2000 (bcm, source: IEA, 2002)

5 Net Inter-Regional Natural Gas Trade Flow, 2030 (bcm, source: IEA, 2002)

6 Agenda 1. The Issue: Internationalization of Natural Gas Markets 2. Theory and Data 3. Model 1: Cointegration of International Gas Prices 4. Model 2: Convergence of Trans-Atlantic Gas Prices 5. Conclusions

7 2. Theory: Cointegration, the Law of One Price (LOP), and Convergence Cointegration: -x t, a N-dimensional process, is co-integrated if each component of the process is I(1) but there exists v, a N-dimensional vector, such that v‘x t is I(0)  Johansen Test ~ Model 1 Law of one price: -LOP is equivalent to having every relative price in the system constant in the long term α ~ transportation costs, quality, risk premium, etc. β ~ relationship between the prices β = 0 no market integration β = 1 LOP holds; markets are fully integrated; proportionate prices Convergence: -A dynamic structural change, time-varying coefficient models  Kalman Filter ~ Model 2 β(t) ~ relationship between the prices β = 0 no market integration β = 1 LOP holds; markets are fully integrated β  1 increasing market integration over time lnp 1 = α + β*lnp 2 +e t lnp 1t = α(t) + β(t)*lnp 2t + e t

8 Literature: Integration of regional gas markets North America - De Vany and Walls (1995): Gas spot prices in several locations (hubs) are increasingly cointegrated with open access to the pipelines (post FERC Order 436) - King and Cuc (1996): price convergence in regional markets, but also a “split” between Eastern and Western region - Serletis (1997): Bi- and multivariate tests for co-integration, indicating that North American natural gas spot markets are integrated (no “split”) Europe (Asche, Osmundsen, Tveteras, 2001, 2002) - Cointegration of European gas import prices (from Russia, Norway, Netherlands) - Cointegration of domestic gas prices, e.g. Belgium, France, Germany

9 Prices Used in this Study Henry Hub Pipe USA LNG USA Pipe Europe LNG Europe LNG Japan Brent

10 Monthly Data Summary Statistics (until mid-2002) Variable No. of obs. MeanStd. Dev.MinMaxSkew.Kurt. Brent Level Log Pipe Europe Level Log LNG Europe Level Log LNG Japan Level Log Henry Hub Level Log Pipe USA Level Log LNG USA Level Log

11 Unit Root Tests All variables are I(1) MarketLog LevelsFirst difference of log Levels ADFPPADFPP Brent ***-9.55*** LNG USA *-5.47***-13.44*** LNG Europe *** Pipe Europe ***-10.00*** LNG Japan *-9.57*** Henry Hub ***-8.50*** Pipe USA ***-9.55*** Tests for prices in level use a constant but not a time trend. Tests for first differences are performed with neither intercept nor linear trend. One / two / three asterisks indicate significance at the 10% / 5% / 1 % level, respectively.

12 Agenda 1. The Issue: Internationalization of Natural Gas Markets 2. Theory and Data 3. Model 1: Cointegration of International Gas Prices 4. Model 2: Convergence of Trans-Atlantic Gas Prices 5. Conclusions

13 European LNG, European Pipeline and Japanese LNG (logged) are largely cointegrated …

14 … and so are American LNG, American Pipeline and Henry Hub (logged), at least since 1999

15 But: European and North American Prices?

16 Bivariate Johansen Test Results Support for the “regional divide” Henry HubPipe USALNG USALNG EuropeBrentLNG Japan Pipe USA 11.25* 18.07* 4.44** LNG USA 16.44*** 27.75*** 7.75*** 14.60** 38.42*** 19.58*** LNG Europe 15.05** ** Brent ** *** 33.89*** 0.30 LNG Japan * 5.83** *** 42.60*** 12.28*** 14.50** 59.37*** 41.10*** Pipe Europe *** 21.00** *** 34.45*** * 2.93* Cointegration No evidence of cointegration - First Line = VECM1 (neither intercept nor trend) in CE - Second Line = VECM 2 (without trend) in CE - Third Line = LR trace statistic to restrict VECM 2 to VECM 1

17 Estimated Cointegration Vector and the Law of One Price (selected statistics) Pair LOP Likelihood Ratio Cointegration Vector (stand. err.) LNG Europe, Brent 23.25*** 1, (0.02) Brent, LNG Japan 39.2*** 1, (0.04) LNG Europe, LNG Japan , (0.14) Henry Hub, LNG USA 6.66*** 1, (0.07) LNG USA, Pipe USA 16.21*** 1, (0.05)

18 Results from Model 1: Regional Market Integration, but not Trans-Atlantic Henry Hub Pipe USA LNG USA Pipe Europe LNG Europe LNG Japan Brent

19 Agenda 1. The Issue: Internationalization of Natural Gas Markets 2. Theory and Data 3. Model 1: Cointegration of International Gas Prices 4. Model 2: Convergence of Trans-Atlantic Gas Prices 5. Conclusions

20 Towards Cointegration of Spot Gas Prices in Europe and North America?

21 Kalman Filter (NBP – Henry Hub) - Two periods of “convergence“, stronger relations in winter periods  Some linkage between North American and European gas prices, but by far not systematic

22 Agenda 1. The Issue: Internationalization of Natural Gas Markets 2. Theory and Data 3. Model 1: Cointegration of International Gas Prices 4. Model 2: Convergence of Trans-Atlantic Gas Prices 5. Conclusions

23 5. Conclusions -The European/Japanese natural gas markets and the North American markets seem to be highly integrated within themselves - Even so, the law of one price does not hold in any of the regional price relations - For the period under observation, there seems to be no integration between the gas markets in Europe/Japan and North America - However, analysis of recent data indicates at least some convergence between European and North American gas prices  The dynamic evolution of the trans-atlantic market, with increasing spot-trading and arbitrage, might lead to a further integration of European and North American gas markets and prices

24 Hypothesis for Further Research: Trans-Atlantic Market Integration Henry Hub Pipe USA LNG USA Pipe Europe LNG Europe LNG Japan Brent

25 Literature Asche, Frank, Petter Osmundsen, and Ragnar Tveteras (2001): Market Integration for Natural Gas in Europe. International Journal of Global Energy Issues, Vol. 16, No. 4, Asche, Frank, Petter Osmundsen, and Ragnar Tveteras (2002): European Market Integration for Gas ? Volume Flexibility and Political Risk. Energy Economics, Vol. 24, De Vany, Arthur and David Walls (1993): Pipeline Access and Market Integration in the Natural Gas Industry: Evidence from Cointegration Tests. The Energy Journal, Vol. 14, No. 4, De Vany, Arthur and David Walls (1993): The Emerging New Order in Natural Gas – Market versus Regulation. Querum Books, Westport. Deutsche Bank (2003): LNG: going… going… Gone Global. Global Equity Research. Engle, Robert F. and Clive W.J. Granger (1987): Cointegration and Error Correction: Repreentation, Estimation and Testing. Econometrica, Vol. 55, European Commission (2001): Green Paper – Towards a European Strategy for the Security of Energy Supply. Luxembourg, Commission Document COM(2000)769final. Hartley, Peter R., and Dagobert L. Brito (2001): New Energy Technologies in the Natural Gas Sectors. Houston, Texas, The James A. Baker III Institute for Public Policy. Hendry, D. and K. Juselius (1999): Explaining Cointegation Analysis: Part II. Oxford, Nuffield College, Lecture Notes. International Energy Agency (2002): Flexibility in Natural Gas Supply and Demand. Paris, OECD. International Energy Agency (2004): Security of Gas Supply in Open Markets – LNG and Power at a Turning Point. Paris, OECD. Jensen, James (2003): The LNG Revolution. The Energy Journal, Vol. 24, Johansen, S. (1988): Statistical Analyis of Cointegration Vectors. Journal of Economic Dynamics and Control, Vol. 12, King, Martin and Milan Cuc (1996): Price Convergence in North American Natural Gas Spot Markets. The Energy Journal, Vol. 17, No.2, Meinhold, Richard and Nozer Singpurwalla (1983): Understanding the Kalman Filter. The American Statistician, Vol. 37, No. 2, Serletis, Apostoles (1997): Is there an East-West Split in North American Natural Gas Markets? The Energy Journal Vol. 1, Serletis, Apostoles and J. Herbert (1999): The Message in North American Energy Prices. Energy Economics Vol. 21,

26 BACKUP

27 Data (USD/Mbtu) Henry Hub Brent Pipeline Europe Sources: IEA „Energy Prices and Taxes“ (several issues); Oil and Gas Journal Database (Henry Hub)

28 Multivariate Johansen Test Results Group Trace StatisticLikelihood Ratio Statistic r = 0r ≤ 1 Model 1/ Model 2 Price out of coint. space LNG Japan, Brent, Henry Hub 24.19*** 65.68*** *** Henry Hub 0.08 LNG Europe, LNG USA, Henry Hub 36.00*** 52.13*** 12.00* *** LNG Europe 0.50 LNG Europe, LNG USA, Pipe USA *** *** LNG Europe 0.48 Brent, LNG Europe, LNG USA 37.46*** LNG USA LNG Europe, LNG Japan, LNG USA 39.80*** 58.03*** *** LNG USA 4.67**