The causal relationship in North American energy production

• DOI: http://doi.org/10.1111/opec.12104
• Date: 01 September 2017
• Published date: 01 September 2017

The causal relationship in North American

energy production

Neil A. Wilmot and Ariuna Taivan

Department of Economics, Labovitz School of Business and Economics, University of Minnesota Duluth,

1318 Kirby Drive Duluth, MN 55812, USA. Email: nwilmot@d.umn.edu Email: ataivan@d.umn.edu

Abstract

Crude oil and natural gas production is examined to investigate the cross-country causal

relationship and interconnectedness of these markets, within the North American context. A vast

infrastructure network, consisting of pipelines and railroads that connect the US and Canadian

markets, with virtually all of Canada’s crude oil and natural gas exports flowing south. The study is

undertaken within the context of the recent US shale energy revolution based on technological

advancements in drilling and hydraulic fracturing. Unique to this study is the use of production

data, rather than the archetypal energy prices, to investigate the presence of bilateral relationships.

Monthly, country level data on crude oil and natural gas production, over the period 2002 through

2015, is utilised. The results of standard unit root tests indicate that the production series are non-

stationary in levels, while cointegration test indicate that the markets are integrated. A bidirectional

relationship is found for the crude oil market. In contrast, a unidirectional relationship is observed

in the gas market –US natural gas production causes Canadian natural gas production.

1. Introduction

Over the last decade, the shale gas and tight oil revolution has dramatically changed the

extraction of energy commodities in the United States, resulting in a significant increase

in supply. The revolution was brought about by the combination of advances in drilling

and extraction. The first, horizontal drilling, allowed operators to drill sideways at certain

depths, exposing more of the reservoir, which permits greater recovery of the resource.

The second, hydraulic fracturing (fracking), uses the concentrated pressure of water,

sand and chemicals to create small fractures in the rock which stimulates the flow of

natural gas or crude oil. The 2002 acquisition of Mitchell Energy by Devon Energy

Corp. has been highlighted as a turning point in US natural gas production (Wang et al.,

2014). Since this time, the United States has seen a 12-fold increase in the production of

natural gas from shale, leading to a dramatic decrease in the amount of gas imported.

According to the Energy Information Administration [EIA] (2016a), in 2015 shale gas

JEL classification: Q40, C22.

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production (42.4 bcf/day) represented the largest source of US natural gas production (90

bcf/day).

Similar techniques have been applied in the domestic production of crude oil, leading

to a corresponding transformation in the production of US crude oil from shale

formations.

1

The EIA (2016b) estimates that in 2015 approximately 50% of domestic oil

production derived from hydraulically fractured wells, which represents a 4100%

increase in this type of production over the last 15 years. This rapid increase in

production has had profound implications on domestic energy markets, particularly in

terms of US energy imports. This supply shock has led to the reversal of a four decade

oil ban on the exportation of crude oil from the United States. In addition, US facilities

originally designed and constructed to ‘unload’foreign natural gas for US consumption,

have recently been converted to export natural gas.

The Canadian experience with shale extraction has been relatively muted, when

compared to the US experience. Modern Canadian shale gas production began in the

Montney Formation, in 2005, rising to 4% of Canadian production in 2014 (NRC, 2016).

Tight oil production in Canada, which accounts for more than 10% of production, occurs

mostly in Western Canada. The Western Canadian Sedimentary Basin (WCSB), which

contains abundant supplies of crude oil and natural gas, stretches from Manitoba to

British Columbia. Given that the majority of Canada’s energy commodity exports are

directed to the United States, the expeditious change occurring in US production is

expected to have an impact on Canada’s energy commodity production. This paper

investigates this possibility by studying the dynamics of crude oil and natural gas

production in the United States and Canada. Interest lies in an empirical examination of

the causal nature, in the Granger sense, of the North American energy commodity

production relationship. The remainder of the paper is as follows. Section 2 examines

how the literature perceives the relationships in both the crude oil and natural gas

markets. Section 3 discusses the empirical strategy and data, while section 4 reports the

results of the empirical analysis. A discussion of the empirical results is presented in

section 5, while Concluding remarks are contained in section 6.

2. Review of literature

The assertion of a global crude oil market is widespread; however, natural gas markets

tend to be regionalised. As early as the 1980s, the crude oil market has been described as

‘one great pool’(Adelman, 1984), with the implication that crude oil prices from

different regions are linked. With a focus on prices, much of the subsequent literature has

provided support for integrated crude oil markets (Ewing and Harter, 2000; Wilmot,

2013). Hammoudeh et al. (2008) examines four benchmark crude oil price series, which

are differentiated by region as well as physical properties. The authors report the

OPEC Energy Review September 2017 ©2017 Organization of the Petroleum Exporting Countries.

240 Neil A. Wilmot and Ariuna Taivan