Shale Gas Boom Affecting the Relationship Between LPG and Oil Prices.

• Author: Oglend, Atle

1. INTRODUCTION

   The U.S. natural gas market has changed dramatically in recent years. The shale gas boom has increased domestic natural gas production to the degree that only minimal LNG imports might be required to meet domestic demand in the future. After George P. Michell's pioneering work for one and a half decade, the use of hydraulic fracking had a commercial breakthrough in the late 1990s in the Barnet Shale. Devon Energy took this breakthrough further when they combined the use of hydraulic fracking with horizontal drilling in 2003 (Yergin, 2011). This combined development allowed the recovery of shale gas at significantly reduced cost. This has led to an influx of so called unconventional gas on the domestic market. In lack of sufficient export capacity this additional supply has depressed U.S. natural gas prices substantially relative to pre shale gas levels.

   Prior to the shale gas boom, U.S. oil and natural gas prices where integrated (Bachmeier and Griffin, 2006; Villar and Joutz, 2006; Neumann, 2009; Erdos, 2012), even though the relationship was weak and a significant share of natural gas prices was unaccounted for by oil prices (Parsons and Ramberg, 2012). The integration of U.S. oil and natural gas markets was established through intercontinental gas-to-gas competition (Neumann, 2009) and domestic inter-fuel substitution. (1) In the Manufacturing Energy Consumption Survey for 2002, the U.S. Energy Information Administration pointed out that "many manufacturers have the ability to substitute the consumption of one fuel for that of another when the economic conditions call for making such a change" (Villar and Joutz, 2006). The heavily oil indexed European and Asian gas market (Asche et al., 2002; Asche et al., 2006; Siliverstovs et al., 2005) also ensured that U.S. natural gas was integrated with global oil price as long as intercontinental arbitrage lead to sufficient gas-to-gas competition. This arbitrage relationship is contingent on sufficient gas transport capacity between regions. Expecting increased U.S. need for imports, LNG gasification capacity was substantially increased. However, with the shale gas boom the global gas trade flow changed unexpectedly. In lack of gas export facilities, intercontinental gas competition towards the U.S. broke down. Consequently, U.S. natural gas is no longer integrated with U.S. oil prices (Erdos, 2012). (2)

   Much focus in the literature has been directed towards the relationship between oil and natural gas markets. Less attention has been paid to other important petroleum products, and their relationship with oil and natural gas markets. Westgaard et al. (2008) and Myklebust et al. (2010) examine the price dynamics of propane, butane and naphtha traded in the north European market. They find that prices contain a random walk component making price predictions challenging. In light of discussions of the relationship between oil and natural gas, it seems relevant to consider the role of other petroleum markets which are related to both oil and natural gas. One such market segment is Liquefied Petroleum Gases (LPG). LPGs such as propane and butane are related to oil and natural gas both on the demand side (through its use for fuel and heating) and the supply side (production comes from both natural gas liquids processing and crude oil refining). It is reasonable to assume that the state of the liquids markets can affect the relative prices of oil and natural gas. High liquids prices, due to for example high oil prices, might increase gas production and hence depress gas prices (because of the associated gas from natural gas liquids fractionating). This implies that the relationship between oil and natural gas prices do not only depend on direct inter-fuel substitution or gas-to-gas competition but also the state of the liquids markets.

   In this paper we investigate the relationship between LPG (as measured by propane and butane), oil and natural gas prices in the U.S. Our main research question is whether the shale gas expansion, which has affected the oil/natural gas relationship, has also affected the relationship between LPG and oil prices. Even though the oil price has historically been the main determinant for LPG prices, the new supply of LPG from shale gas operations might have been sufficient to move LPG prices away from oil prices. The shale gas boom provides a natural experiment to evaluate the effects of a significant and persistent supply shock on the historically stable LPG/oil price relationship. This question is of interest not only in terms of establishing the relationship between oil, natural gas and LPG markets, but also in terms of the future development of U.S. energy markets. If the LPG markets have remained largely unaffected by the shale gas boom, absorbing most of the supply without affecting long run prices, it is more likely that low natural gas prices might persist for a significant period. If however the additional supply can affect the LPG/oil relationship it is more likely that natural gas production might decline as future shale gas operations are likely to become less profitable. For gas operations the liquids markets have ensured an exposure to world energy markets in a time where lack of natural gas exports have led to a segmented and depressed U.S. natural gas market. The stability of the liquids markets is therefore important in terms of the need for natural gas exports. A liquids market largely unaffected by the domestic natural gas market will reduce the need for natural gas exports. However, if U.S. liquids markets move in the direction natural gas price has moved this will make additional export capacity more important.

   In the next section we discuss the LPG markets and their relationship to natural gas and oil. Thereafter, we investigate the relationship between natural gas and oil prices with a focus on testing for a structural change. Using the data of the oil/natural gas structural change we investigate the full markets, including oil, propane, butane and natural gas, using a generalized cointegrated vector autoregressive model allowing for structural breaks. Testing the stability of the long-run relationships is then done by imposing restrictions on the general model.

2. LIQUEFIED PETROLEUM GASES

   Liquefied petroleum gases (LPG) are light hydrocarbon gases: propane, isobutane and butane. (3) They are part of natural gas liquids (NGL), the light end of hydrocarbons. (4) LPG is produced in two industries: NGL processing and crude oil refining. Historically, approximately 60% of the LPG production has come from natural gas processing, and 40% from crude oil refining. With reduced LPG production from refineries, about 3/4 of LPG production now comes from natural gas processing plants. U.S. gas plant production of liquefied petroleum gases has increased in recent years, being on an upward trend since around 2009 (figure 1). The total 2012 production of ethane, propane and butane were respectively 33%, 31% and 29% above their 2009 levels. Also Isobutane has increased, although less in percentage terms (20%).

   The increase in domestic production has been accompanied by an increase in exports. The export increase is due in most part to propane, where most of the additional propane produced has been exported. Indeed, propane accounts for almost all LPG exports in the EIA data; butane accounting for the difference. Figure 2 shows U.S. exports of LPG and U.S. exports of propane. The relationship between domestic propane and butane prices relative to crude oil and natural gas will be formally analyzed in the empirical analysis of the paper. For example, we examine whether the increase in butane and propane production have reduced their prices, relative to the oil price. The significant expansion in propane exports would help cushioning its relative price reduction. Butane, on the other hand is helped by having a closer link to the oil market than propane, on the demand side.

   While propane is used as petrochemical feedstock, fuel and for heating purposes, butane is also used as a blending component for motor gasoline. According to Dow Chemical (2010), 85% of butane in the U.S. was used for gasoline blending in 2008, 5% for chemical feedstock and 5% as fuel. As such, LPG competes to some degree directly with crude oil and other crude oil derivatives (for butane), in addition to natural gas for heating (for propane); while also to a certain degree being mutual substitutes. While propane has a boiling point at -42 degrees Celsius, butane has a boiling point at 0 degrees Celsius and is less efficient as a fuel in cold weather. As butane is more energy efficient, the use of propane and butane as a fuel depends on the local temperatures.

   The LPG markets provide a link between the natural gas and the oil market. Historically, propane and butane prices have been strongly influenced by crude oil prices due to a strong demand side connection. Although the natural gas industry is the major producer of propane and butane, natural gas prices have historically been less informative on LPG prices. For propane, low natural gas prices make propane less attractive for heating in the residential and commercial sectors. Also, abundant quantities of ethane from NGL fractionating make propane less attractive for ethylene production. During 2012 we have also seen that ethane has been rejected and left in the natural gas stream due to low prices and lack of demand from the petrochemical industry (ethylene cracking) (EIA, 2013a). This situation creates a surplus of propane, and we have seen an increase in propane (and propylene) exports from 50.000 barrels/day in 2008 to 170.000 barrels/day in 2012 (EIA Data). At the same time the price of butane has been supported by crude oil and gasoline prices.

   The LPGs are a subset of the NGLs. The typical barrel of NGLs consist of 40-45% ethane, 25-30% propane, 5-10% normal butane, 10% iso-butane...