The Informational Efficiency of European Natural Gas Hus: Price Formation and Intertemporal Arbitrage.

• Author: Nick, Sebstian

1. INTRODUCTION

The price signals of commodity spot and futures markets are of economic significance for market participants and various stakeholders, as they tend to ensure an efficient allocation of resources. However, the extent to which commodity spot and futures prices fulfil their function crucially depends on the informational efficiency of the respective market. Economic theory suggests that sufficient market liquidity facilitates the processing of information into valid price signals. Thus, the efficiency of markets that are still immature and suffer a lack of liquidity may be questioned. This holds true for the natural gas wholesale markets within continental Europe. Spot markets for immediate delivery of natural gas as well as futures markets have emerged rather recently as a consequence of the natural gas directives of the European Parliament (EU, 2003; EU, 2009), aiming towards an integrated and competitive European gas market. Liquidity on these markets, though rising, is still low compared to the mature gas markets in the UK or the U.S. The limited liquidity of both spot and futures markets at continental European gas hubs has entered the scientific debate, as European gas pricing is currently undergoing a transition phase from traditional oil indexed pricing of long-term contracts (LTC) to an increase in the significance of hub-based pricing. (1)

The shifting towards hub-based pricing of natural gas in continental Europe is based on the assumption that the respective hubs are capable of providing valid price signals. In this context, this work seeks to shed light on the informational efficiency of European gas hubs by empirically investigating two areas that allow for valuable insights with regard to market efficiency: The price discovery process at spot and futures markets for the same underlying asset and the efficiency of intertemporal arbitrage between these two markets. It draws upon econometric approaches for six major European gas hubs, where the mature and liquid British hub serves as a benchmark for the other hubs. (2)

This paper extends empirical research on natural gas markets in various ways: Foremost, it is innovative as it analyzes the informational efficiency of the European gas hubs through the investigation of the price formation process and the efficiency of intertemporal arbitrage. Second, it explicitly addresses the specific characteristics of the European gas market, namely low liquidity and technical constraints, by nonlinear econometric approaches. Third, it allows innovative insights into the evolution of informational efficiency at European gas hubs over time. The empirical results of this study yield comprehensive insights into the informational efficiency on European natural gas markets. First, they show that the futures market is more informationally efficient than the spot market as price discovery generally takes place on the futures market. Second, the analysis of intertemporal arbitrage reveals that there is a stable long-run equilibrium between spot and futures markets, but short-run equilibrium deviations can be quite persistent, pointing towards significant frictions in intertemporal arbitrage trading. Third, the increase in liquidity seems to have improved informational efficiency only at two of the hubs considered.

The remainder of the paper is organized as follows: Section 2 provides the underlying economic theory and discusses relevant previous research. Section 3 presents the data used in this study and preliminary statistical tests, while Section 4 provides information with regard to market liquidity and the flexibility potential of gas storages at the European gas hubs. In Section 5, price discovery at European gas hubs is investigated using linear and nonlinear causality testing. Section 6 explores the long-run relationship of spot and futures markets at the considered hubs and analyzes the efficiency of intertemporal arbitrage. A state-space approach to capture the evolution of inter-temporal arbitrage efficiency over time is specified in Section 7. Section 8 concludes.

2. THEORETICAL CONSIDERATIONS AND PREVIOUS RESEARCH

   Efficient markets are expected to process relevant information instantaneously (Fama, 1970). Within an intertemporal context, this implies that spot and futures markets should react simultaneously to news that affects both markets. Consequently, there should be no structural lead-lag relationship between the two markets (Zhang and Jinghong, 2012). This is in line with the weak-form efficiency hypothesis stating that excess returns on spot and futures markets should be unpredictable as otherwise risk-free profits may be generated (Arouri et al., 2013). However, if one of the markets is more efficient in processing information, this market may become the leading market. In that case, price discovery takes place at the leading market and the price signal is subsequently transmitted to the following market.

   There are various hypotheses with regard to the differences in informational efficiency of spot and futures markets and the resulting systematic relationship. Silvapulle and Moosa (1999) and Bohl et al. (2012) suggest that futures prices may react quicker to the arrival of information, since informationally efficient speculators are only active in this market. As a result, information processing and price discovery occur in the futures market and the spot prices adjust accordingly until an arbitrage-free equilibrium is achieved. In contrast, Moosa and Al-Loughani (1995) argue that the spot market should lead the futures market because arbitrageurs react to spot price movements by engaging in futures market positions. Empirical research on price discovery on natural gas spot and futures markets is scarce. Dergiades et al. (2012) explore linear and nonlinear causality relationships between spot and futures prices at the U.S. gas hub. Focusing on the northwest U.S. natural gas market, Gebre-Mariam (2011) tests for causality among spot and futures market prices and market efficiency by drawing upon cointegration techniques.

   Concerning the European gas market, Stern (2014) argues that the oil price indexation of natural gas imports to Europe does not reflect market fundamentals anymore, triggering a switch to hub pricing in Europe. The regional integration of European gas hubs and the efficiency of regional price arbitrage have been empirically explored (e.g., Neumann et al., 2006; Growitsch et al., 2012). In the context of regional market integration, Keyaerts and D'haeseleer (2012) discuss and quantify potential gains in market efficiency induced by cross-border procurement of natural gas balancing services. Asche et al. (2013) empirically analyze the relationship between European natural gas spot prices, the prices of long-term natural gas import contracts and the price of crude oil. In line with Growitsch et al. (2012), Asche et al. (2013) find a high level of regional market integration using cointegration technique while their findings point towards significant influence of crude oil prices on both spot and contract prices for natural gas.

   The price formation process at the European spot and futures markets, in contrast, has thus far only received limited attention. Schulz and Swieringa (2013) investigate the price discovery process of the European natural gas market using high-frequency data. Based on a regression approach applied to different European physical and financial natural gas contracts, they conclude that the futures contract of the British hub NBP displays greater price discovery than the other spot and futures markets considered in their study. Moreover, the NBP futures contract price exhibits the largest contribution to the long-run equilibrium between the different markets analyzed. Schulz and Swieringa (2013) attribute this finding to the superior maturity of the British natural gas hub.

   The theory of storage suggests that spot and futures markets for storable commodities are linked through transactions of market participants optimizing their portfolios intertemporally, resulting in a stable long-run relationship between these markets (Working, 1949). The cost-of-carry condition is characterized by the equivalence of the price of a futures contract in period t with the delivery in period t + k, [F.sub.t+k|t], and the spot price compounded with the respective interest rate [r.sub.t+k|t], [S.sub.t](1 + [r.sub.t+k|t]) plus the storage costs [w.sub.t+k|t] adjusted for the convenience yield [c.sub.t+k|t] (i.e., the economic benefit of physical ownership). This condition can be stated as

   [F.sub.t+k|t] = [S.sub.t](1 + [r.sub.t+k|t]) + [w.sub.t+k|t]-[c.sub.t+k|t] (1)

   Deviations from the intertemporal equilibrium may trigger arbitrage activity by market participants. In this context, arbitrage can be considered as the economic activity of generating risk free profits by taking advantage of the substitutability between commodity spot and futures markets (Schwartz and Szakmary, 1994). As outlined by Huang et al. (2009), a long arbitrage position, i.e., buying the commodity on the spot market and selling a futures contract, is profitable if the basis [b.sub.t]=[F.sub.t]-[S.sub.t] exceeds the difference of warehouse costs and convenience yield, adjusted for the interest rate r:

   bt--Strt + kt>wt + k\t--ct + ku (2)

   In contrast, a short arbitrage position, i.e., selling the commodity on the spot market and buying a futures contract, generates profits if

   [mathematical expression not reproducible] (3)

   The theory of storage has been empirically analyzed for different commodity markets by Fama and French (1987), and more recently by Considine and Larson (2001) and Huang et al. (2009). With regard to the European natural gas market, Stronzik et al. (2009) find significant deviations from the theory of storage equilibrium for three European hubs for the period 2005 to 2008 using indirect testing procedures. However, the...