The relationship between crude oil and natural gas spot prices and its stability over time

Abstract

The historical basis for a link between crude oil and natural gas prices was examined to determine whether one has existed in the past and exists in the present. Physical bases for a price relationship are examined. An econometric modeling exercise seeks to establish whether a stable price relationship exists and to define it through the use of a vector error correction model. The model identifies strong evidence of cointegration between the crude oil and natural gas spot price series in the United States. It conditions the predicted natural gas price volatility through exogenous variables related to weather and supply. Once identified, the relationship is clarified more efficiently through the implementation of a conditional error correction model. The model is then utilized to simulate the effects of weather shocks, seasonality, supply deviations and hurricane activity on the cointegrating relationship between crude oil and natural gas. Finally, an analysis is conducted to test whether the relationship shifts over time to new equilibria. The results of the series of exercises suggest that crude oil and natural gas prices have moved together historically and statistical analysis supports the assumption that the two price series continued to be cointegrated through the end of 2008. The analysis presents evidence that the relationship shifts over time to new equilibria, and the data suggest that these new eqilibria are likewise stable.