The Relationship Between Crude Oil and Natural Gas Prices

October 2, 2006

Abstract: This paper examines the time series econometric relationship between the Henry Hub natural gas price and the West Texas Intermediate (WTI) crude oil price. Typically, this relationship has been approached using simple correlations and deterministic trends. When data have unit roots as in this case, such analysis is faulty and subject to spurious results. We find a cointegrating relationship relating Henry Hub prices to the WTI and trend capturing the relative demand and supply effects over the 1989-through-2005 period. The dynamics of the relationship suggest a 1-month temporary shock to the WTI of 20 percent has a 5-percent contemporaneous impact on natural gas prices, but is dissipated to 2 percent in 2 months. A permanent shock of 20 percent in the WTI leads to a 16 percent increase in the Henry Hub price 1 year out all else equal.

Introduction

Economic theory suggests that natural gas and crude oil prices should be related because natural gas and crude oil are substitutes in consumption and also complements, as well as rivals, in production. In general, the observed pattern of crude oil and natural gas prices tend to support this theory (Figure 1). However, there have been periods in which natural gas and crude oil prices have appeared to move independently of each other. Furthermore, over the past 5 years, periods when natural gas prices have appeared to decouple from crude oil prices have been occurring with increasing frequency with natural gas prices rising above its historical relationship with crude oil prices in 2001, 2003, and again in 2005. This has led some to examine whether natural gas and crude oil prices are related (For example, see Brown (2005), Panagioditis and Rutledge (2004), and Jabir (2006)).

Economic factors link oil and natural gas prices through both supply and demand. Market behavior suggests that past changes in the oil price drove changes in the natural gas price, but the converse did not appear to occur. One reason for the asymmetric relationship is the relative size of each market. The crude oil price is determined on the world market, while natural gas markets, at least for the period of investigation, tend to be regionally segmented. Consequently, the domestic natural gas market is much smaller than the global crude oil market, and events or conditions in the U.S. natural gas market seem unlikely to be able to influence the global price of oil.

This paper seeks to develop an understanding of the salient characteristics of the economic and statistical relationship between oil and natural gas prices. The sample period covers January 1989 through December 2005 which includes:

oil price spikes in 1990 following the invasion of Kuwait

the oil price collapse from the supply glut in 1999

dramatic oil price increases since 2003

substantial natural gas regulatory reform

significant supply shortages in cold winters

the natural gas supply bubble for most of the 1990s

big increases in natural gas prices starting in 2001

The analysis identifies the economic factors suggesting how crude oil and natural gas prices are related, and assesses the statistical significance of the relationship between the two over time. The focus of the econometric analysis is primarily on the movements in the prices; the economic factors are not explicitly modeled. Nevertheless, a significant stable relationship between the two price series is identified. Oil prices are found to influence the long-run development of natural gas prices, but are not influenced by them.