The Relationship between Crude Oil and Natural Gas Prices: The Role of the Exchange Rate.

AuthorHartley, Peter R.
  1. INTRODUCTION

    A number of studies have documented that oil and natural gas prices in the United States are cointegrated. One might expect the prices

    to be linked because fuels can be substituted in some uses. Variability in the relative price, however, has raised doubts about the results. In the last few years in particular, the price of natural gas relative to crude oil has deviated dramatically from its recent historical norms, challenging yet again the notion that a stable long run relationship exists between the two prices.

    Understanding the relationship between crude oil and natural gas prices, especially its permanence, is important to many stakeholders. Commercially, it is important when considering investments in gas-to-liquids or other technologies (such as compressed natural gas) enabling natural gas to penetrate the predominantly oil-using transportation sector. It is also important when considering LNG exports to consumers facing oil-indexed prices. Understanding the pricing relationship also can be important for evaluating policies to promote the use of one fuel over another, for example in the transportation sector.

    We extend previous work in this area by providing an additional explanation for the recent drift in the crude oil-natural gas relative price. We begin with a theoretical analysis that builds on the observation that while the U.S. trades crude oil internationally, natural gas predominantly trades in a continental market leaving little opportunity for direct arbitrage with European and Asian markets. As recently as the early 2000s, many were expecting increased North American LNG imports to facilitate arbitrage between continental gas markets. Growth in shale gas production has, however, kept the North American natural gas market largely isolated, and prevented spot natural gas prices in North America, Europe and Asia from reaching an equilibrium reflecting transport costs. (1) This implies, as will be shown, that the nominal value of the U.S. dollar systematically affects the crude oil-natural gas relative price.

    In the empirical analysis, we use monthly data from January 1995 through December 2011 to examine the relationship between oil and natural gas prices. We find evidence of a stable long run cointegrating relationship between the prices once we include a technology variable and the U.S. dollar nominal exchange rate.

  2. PREVIOUS RESEARCH

    Several papers examining the cointegration of natural gas and oil prices are of particular relevance to the current study. Villar and Joutz (2006) were among the first to highlight the apparent decoupling of WTI crude oil and Henry Hub natural gas prices. They documented that the cointegrating relationship between the two prices exhibited a positive time trend, indicating an evolving rather than constant long run relationship. After allowing for the time trend, Villar and Joutz estimate an error correction model (ECM) that includes exogenous variables such as natural gas storage levels, seasonal dummy variables, and dummy variables for other transitory shocks.

    Brown and Yucel (2008) used an ECM to analyze weekly prices from January 1994 through July 2006. They found a stable cointegrating relationship over this period, but also reported that a cointegrating relationship does not exist if they consider the shorter period of June 1997 through July 2006. Using the cointegrating relationship from the longer time period, they found that short run deviations could be explained by market fundamentals such as storage levels, weather, and production shut-in due to hurricanes.

    Hartley, Medlock and Rosthal (2008) provide a technological explanation for the apparent change in the relationship between crude oil and natural gas prices for the period 1990 through 2006. Using monthly data, they estimate a vector error correction model (VECM) and find a stable cointegrating relationship between natural gas and crude oil prices after explicitly accounting for technological change. In particular, they assume that competition between fuels to generate electricity depends on costs per megawatt hour, so the heat rate (or thermal efficiency) of the plant, not just the fuel price, determines fuel use. Notably, the dramatic increase in high thermal efficiency combined-cycle power generation capacity in the early 2000s lowered the cost of producing electricity with natural gas. Since oil and natural gas often competed in the power sector from 1990 through 2006, technological change would have affected the long run relationship between natural gas and crude oil prices.

    More recently, Ramberg and Parsons (2012) found that the cointegrating relationship was unstable. In particular, they show that while the prices may be tied together, substantial shifts in the underlying relationship can make the confidence interval for the price relationship very large. They also estimated an ECM to explain short run dynamic adjustment of natural gas and crude oil prices using variables similar to those introduced in Brown and Yucel (2008). They conclude that even if the long run pricing relationship changes, a relationship should eventually re-establish as new technologies introduce new margins of substitution between the fuels.

    In this paper, we first introduce a simple model where oil is traded between a home and foreign market but natural gas is a non-traded good. If there are ample opportunities to substitute between crude oil and natural gas, the lack of direct arbitrage between the two natural gas markets is less important. Competition with oil will heavily influence natural gas prices, enabling de facto arbitrage through trade in crude oil. If the ability to switch fuels is constrained in one market, however, then the exchange rate will play an important and unambiguous role (2) in determining the relative price of natural gas to crude oil.

    In the past several years, substitution between crude oil and natural gas has virtually disappeared in the U.S., as oil use for power generation has become almost entirely restricted to diesel and residual fuel oil peaking plants. The decline in substitution capability occurred after changes in heat rates and relative prices produced substantial grid-level switching from oil (largely residual fuel oil) to natural gas. The two fuels no longer experience a broad competitive margin. This has apparently left gas to seek a new competitive margin, perhaps with coal. While this is a reasonable thesis, the role of the exchange rate is often ignored, a flaw which this paper highlights.

    After estimating a cointegrating relationship that includes the exchange rate and a variable to capture technological change, we follow the previous literature in relating the dynamic adjustment process to deviations from the estimated long run relationship and to market fundamentals such as storage levels and weather shocks.

  3. A SIMPLE TRADE MODEL

    We assume two representative countries produce and consume both natural gas and crude oil. Moreover, each can switch between natural gas and crude oil in end-use. Crude oil is internationally traded, but natural gas is a non-traded good. We will show that this simple model implies that the exchange rate is an important systematic determinant of the relative price of natural gas to crude oil.

    Assuming constant elasticity natural gas market supply and demand relationships in the "home" country the percentage changes (3) in supply s and demand d can be written

    [s.sub.g,h] = [z.sub.s,h] + [[beta].sub.1,h][p.sub.g,h] (1)

    and

    [d.sub.g,h] = [z.sub.d,h] - [b.sub.1,h][p.sub.g,h] + [I.sub.sw,h][b.sub.2,h][p.sub.o,h] (2)

    where [z.sub.sh] and [z.sub.d,h] denote exogenous shocks to supply and demand growth respectively and [I.sub.swh] is an indicator variable equal to one when fuel switching capability exists and zero otherwise. The variable [p.sub.gh] denotes the percentage change in the price of natural gas in the "home" country, h, and [p.sub.oh] denotes the percentage change in the price of oil.

    If the home country does not trade natural gas, a necessary condition for market equilibrium is [d.sub.gh] = [s.sub.gh], so that for a given oil price we have

    [p.sub.g,h] = [z.sub.h] + [[lambda].sub.h][p.sub.o,h] (3)

    where [z.sub.h] = ([z.sub.d,h] - [z.sub.s,h])/([[beta].sub.1,h] + [b.sub.1,h]) and [[lambda].sub.h] = [[b.sub.2,h] /([[beta].sub.1,h] + [b.sub.1,h])][I.sub.sw,h]. Hence, in this simple formulation, the relationship between crude oil and natural gas prices is primarily determined by the ability to switch between fuels. If [I.sub.sw,h] = 0, so there is no fuel switching capability in the home country, (3) reduces to [p.sub.g,h] = [z.sub.h] and the domestic natural gas price will respond only to exogenous variables affecting domestic supply and demand of natural gas.

    For an autarkic equilibrium to persist, the cost of developing export (if the domestic price is below the foreign price) or import (if the domestic price is above the foreign price) capability must be prohibitive (or disallowed by policy). For example, if trade requires natural gas to be liquefied, the large capital costs of developing LNG liquefaction or regasification capabilities may allow domestic natural gas prices to fluctuate in a wide range for a long time without triggering international trade flows.

    In contrast to natural gas, we assume that the "home" country trades oil as an importer. Assuming oil supply and demand curves analogous to (1) and (2), the percentage change in imports can be approximated by [m.sub.o,h] = [[theta].sub.o,h][d.sub.o,h] + (1 - [[theta].sub.o,.sub.h])[s.sub.o,h] or

    [mathematical expression not reproducible] (4)

    where the exogenous shocks in the oil market are denoted by w, and [[theta].sub.o,h] = [d.sub.o,h]/([d.sub.o,h] - [s.sub.o,h])> 1 is the ratio of total domestic demand for oil to oil imports.

    Aggregating the home country's trading partners into a "composite" foreign country, by analogy with (4), oil exports from the...

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