Long‐term relationships between electricity and oil, gas and coal future prices—evidence from Nordic countries, Continental Europe and the United Kingdom

• DOI: http://doi.org/10.1111/opec.12025
• Author: Sjur Westgaard,Stein Frydenberg,Nora Midtsund,Joseph I. Onochie,Hanna Ueland
• Published date: 01 June 2014
• Date: 01 June 2014

Long-term relationships between electricity

and oil, gas and coal future prices—

evidence from Nordic countries,

Continental Europe and the United Kingdom

Stein Frydenberg,* Joseph I. Onochie,** Sjur Westgaard,***

Nora Midtsund**** and Hanna Ueland*****

*Associate Professor, TrondheimBusiness School, Jonsvannsveien 82, 7004 Trondheim, Norway. Email:

stein.frydenberg@hist.no

**Associate Professor, Bert Wasserman Department of Economics and Finance, Zicklin School of

Business, Baruch College, City University of New York,1 Bernard Baruch Way, New York, NY 10010, USA.

Email: joseph.onochie@baruch.cuny.edu

***Professor, Department of Industrial Economics and TechnologyManagement, Norwegian University of

Science and Technology,Alfred Getz vei 1, 7491 Trondheim, Norway. Email: sjur.westgaard@iot.ntnu.no

****Research Assistant, Norwegian University of Science and Technology,Trondheim, Norway. Email:

nora.midtsund@gmail.com

*****Research Assistant, Norwegian University of Science and Technology,Trondheim, Norway. Email:

hanna.ueland@gmail.com

Abstract

This paper investigates the relationship between futures prices of electricity, on the one hand and

crude oil, natural gas and coal on the other hand, in the United Kingdom, German and Nordic energy

markets. Energy traders and market participants use statistical models in their trading activities.We

seek to establish robust cointegration based models as decision tools for energy commodity spread

trading. Welook at three different markets with different input mixtures, for electricity generation.

Using daily futures data from period 2006 to 2012, we find cointegration between UK electricity

prices and Coal and Gas, and between Nordic electricity prices and Coal. The spread between

German electricity prices and Gas, Oil and Coal prices are also stationary.The consequence of this

finding could be a possible trading strategy which involvesbuying electricity futures and selling gas

or coal when the spread is above the mean and reversingthe strategy when the spread is below the

mean. The suggested strategy assumes a reversionto the mean, which we show takes some time, as

displayed bythe slow speed of adjustment.

1. Introduction

The research question analysed in this paper is whether there is a long term relationship

between electricity prices and prices of energy commodities (oil, natural gas and coal).As

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these energy commodities are used as input in electricity production, our main hypothesis

is that the prices should be related in the long run. In this paper we investigate whether

there is a cointegration relationship between electricity prices and related energyprices for

the United Kingdom (UK), the German and the Nord Pool area (Norway, Sweden,

Denmark, Finland, Latvia, and Estonia), and establish Error Correction Models (ECMs)

for energy prices. We extend the existing literature by investigatingthe most traded energy

futures contracts in Europe, and by analysing up-to-date price series covering the recent

financial crises.

What distinguishes this paper from earlier work is, firstly, that we examine for

cointegration using recent data from Nord Pool, EEX and UK where earlier studies have

focused mainly on the US market. Secondly, earlier studies have mainly concentrated on

spot market integration from a macroeconomic perspective, and not on cointegration from

the perspective of trading/risk strategies in the futures markets.

In the energy industry, a common perception is relatedness of energy prices.As elec-

tricity is produced by mainly gas, coal and hydropower, and less with oil, we hypothesise

that there should be a relation between electricity prices and prices of gas and coal.

Energy commodities are also, to a certain degree, substitutes (e.g. oil and natural gas),

and hence their prices should influence each other. There is also an increased connectiv-

ity across electricity markets in Europe as grids and cables between the areas are being

developed. New technology arrives to the market; on- and off-shore wind power plants,

shale oil development, and improved methods for converting coal to fuel and for extract-

ing solar energy. These have noticeable effects on energy prices and the relationships

among them.

Markets, which to a large extent, base their electricity generation on coal and natural

gas (the UK and German markets) are probably more related to the other energy markets,

compared to the Nord Pool area, where electricity is mainly generated by hydro power.

Figure 1 shows input factors in electricity production in Nord Pool, EEX, and ICE. From

Fig. 1, we wouldexpect a stronger relationship between electricity prices and the prices of

coal, natural gas and crude oil in the UK and Germany than in the Nord Pool. Furthermore,

we wouldexpect a stronger relationship between electricity prices and coal and natural gas

prices than between electricity and crude oil prices in the UK, Germany and Nord Pool.

Consistent with expectation, wefind cointegration between electricity and gas prices in the

UK. We also find cointegration between electricity and coal prices in the UK, Germany

and Nord Pool.We also find cointegration between electricity and crude oil prices, but this

relationship is not so strong, compared to electricity and coal and gas. Coal and natural gas

are the predominant inputs for electricity production in the UK and Germany,more so than

crude oil, which is relatively more expensivein terms of energy content than coal and gas.

Coal is used, on a large scale, for electricity production in Germany, and the interconnec-

tion between electricity markets via power lines in Nord Pool area and Germany may

Long-term relationships between electricity and oil, gas and coal future prices 217

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