Analysis of Price Volatility in Natural Gas Markets
August 17, 2007
This article presents an analysis of price volatility in the spot natural gas market, with particular emphasis on the Henry Hub in Louisiana. The purpose is to address whether natural gas prices have been more volatile in recent years and identify potential market factors that may contribute to price volatility. In addition to a first-order autoregressive error model, several graphical and statistical tools are used to examine trends and determine influencing factors. Although there is no demonstrated long-term trend in volatility, there are seasonal patterns and volatility is correlated strongly with storage dynamics. This report was written by Erin Mastrangelo. Questions or comments should be directed to William Trapmann at william.trapmann@eia.doe.gov or (202)586-6408.
Introduction
The subject of price volatility in natural gas markets has received increased attention in recent years as the market experienced expanding dips and swells in prices while overall prices shifted to a higher level (Figure 1). Volatility is not defined by the level of prices, however, but by the degree of price variation in the market. Therefore, increasing natural gas prices do not necessarily indicate whether a market is volatile. Given that volatility is measured by percent differences in the day-to-day price of natural gas, a large price movement at higher prices may equate to a comparable level of volatility as a smaller price movement when natural gas prices are lower. Although volatility is a key measure of natural gas market movements and fundamentals, expanding daily price movements at any volatility level can have vast impacts on traders and consumers of natural gas. When addressing price risk, it can be important to examine absolute price movements as well as volatility.
Market prices respond to shifts in supply and demand, and the degree of price response relates to the price elasticity of both. Natural gas prices have been particularly sensitive to short-term supply and demand shifts in recent years because of the highly inelastic nature of this market. In the short-term, consumers are limited in their ability to switch fuel sources, and production infrastructure is thought to be operating near capacity. Also, significant lead time is required in order to bring additional domestic or foreign natural gas supplies to market as well as expand pipeline capacity to alleviate transmission bottlenecks. Limited short-term price responsiveness means that natural gas prices will be highly sensitive to market factors such as weather swings or supply disruptions. Inelasticity is characteristic of many energy commodities. However, analyses of natural gas volatility relative to other commodities have ranked it among the highest. Electricity has been the only commodity group with price volatilities consistently higher than those of natural gas.
In the absence of much real-time supply and demand data such as production, natural gas wellhead productive capacity, or natural gas consumption volumes, market participants look to natural gas prices as a barometer for current market conditions. Volatile prices create uncertainty and financial risk in the market and may increase the cost of capital, causing pipeline and other infrastructure investment to be more expensive.
The purpose of this paper is to address whether or not natural gas prices have been more volatile in recent years and identifies potential market factors that may contribute to price volatility. The analysis found that although there is no consistent increasing or decreasing trend in natural gas spot price volatility at the Henry Hub, there is a seasonal pattern with colder months exhibiting considerably higher volatility levels. Also, the analysis indicates that price volatility tends to vary between market locations. Furthermore, the relative level of natural gas in storage has a significant impact on price volatility. When natural gas in storage is high or low compared with the 5-year average level, price volatility at the Henry Hub increases. This effect is exacerbated during the months of the year surrounding the beginning and end of the heating season when storage levels are typically at the highest and lowest levels. Finally, this analysis shows that, even with relatively low levels of volatility, changes in the natural gas price level can have large impacts on the market.