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Weekly Updates1. INTRODUCTION
For many years, pipelines were the primary means for moving natural gas, and natural gas prices were, by and large, determined in the prevailing continental markets. The development of an international market for liquefied natural gas (LNG) and the resulting opportunities for intercontinental arbitrage are seen as creating a world in which movements in natural gas prices are linked between continents. Neumann (2009) finds that shipments of LNG across the Atlantic have enabled some co-movement in natural gas prices between European and North American markets. Increased flows of LNG into the United States and the potential sensitivity of these shipments to price differentials between Europe and North America suggests the possibility of a strengthening relationship between natural gas prices on these two continents.
At the same time, there is considerable evidence linking natural gas price movements in Europe and North America to those for crude oil. Asche et al (2006) and Josse-Vasquez and Neumann (2006) find cointegration between natural gas and crude oil prices in the U.K. market, with Asche et al showing changes in crude oil prices lead those for natural gas. Similarly, Bachmeir and Griffin (2006), Villars and Joutz (2006), Brown and Yucel (2008b) and Hartley, Medlock and Rosthal (2008) find cointegration between natural gas prices in the U.S. market with Brown and Yucel showing that changes in crude oil prices lead those for natural gas.
With different crude oil prices moving closely together on international markets, the link between crude oil and natural gas prices raises the possibility that the co-movement of natural gas prices in European and North American markets is mediated through crude oil prices rather than by gas-to-gas arbitrage facilitated by shipments of liquefied natural gas (LNG). Accordingly, we use a series of econometric tests to determine whether the co-movement between natural gas prices in Europe and North America is mediated through international crude oil prices. These tests reveal that the co-movements of oil and natural gas prices in European and North American markets likely play an important role in the co-movement of natural gas prices between the two continents. LNG may reinforce the link between natural gas and oil prices because most contracts for LNG delivery in Europe are priced against crude oil.
2. PRICE SHOCKS IN OIL AND NATURAL GAS MARKETS
To examine how natural gas price shocks are transmitted across the Atlantic and how oil prices might affect this transmission, we undertake a series of causality tests involving weekly data for natural gas and crude oil prices at major trading nodes over an uninterrupted span of 570 weeks from June 13, 1997 through May 9, 2008. The natural gas prices include Henry Hub in the United States and the National Balancing Point (NBP) in the United Kingdom. The crude oil prices include West Texas Intermediate (WTI) and Brent.
Henry Hub is the principal trading hub for natural gas in the United States. Near New Orleans, Henry Hub comprises a series of 16 pipeline interconnects at a single facility that draw their supplies from the largest concentration of natural gas producing regions in the country and nearby terminals for importing LNG. These pipelines directly serve markets throughout the U.S. East Coast, the Gulf Coast, the Midwest, and up to the Canadian border. Interconnections with pipelines across Texas link the Henry Hub market to those in the U.S. West. Serletis and Herbert (1999) find that the Henry Hub spot price is strongly correlated with the NYMEX futures price, which is the most widely traded natural gas contract in the world. As such, the Henry Hub price represents a national market price for natural gas that is determined relatively close to the wellhead.
The NBP is a pricing and delivery point for natural gas in the United Kingdom. It is similar in concept to Henry Hub, but its location is more diffusely specified as within the United Kingdom's national transmission system without any precise location. The NBP is the pricing and delivery point for the Intercontinental Exchange natural gas futures contract. It is the most liquid gas trading point in Europe and is a major influence on the price that European consumers pay for their gas at home. The NBP is some distance from Spain, where most LNG cargos are imported into Europe, but it is interconnected to continental supplies of natural gas and adjacent to LNG import facilities in the United Kingdom. As such, the NBP price best represents a European market price for natural gas that is determined close to end users.
West Texas Intermediate crude oil (WTI) and Brent are standard marker crude oils on international markets. WTI is a crude oil of a specific gravity and sulfur content delivered at Cushing, Oklahoma. It is used as a benchmark in oil pricing in North America and is the underlying commodity for the New York Mercantile Exchange's oil futures contracts. Bachmeir and Griffin (2006), Villars and Joutz (2006), Hartley, Medlock and Rosthal (2008) and Brown and Yucel (2008b) use WTI to examine the relationship between crude oil and natural gas prices in the United States.
Brent Crude is a blend of 15 oils from the North Sea. Its price is a benchmark for oil produced in Europe, Africa and the Middle East. Asche et al (2006), Josse-Vasquez and Neumann (2006), and Neumann (2009) use Brent to examine the relationship between crude oil and natural gas prices in the United Kingdom.
We conduct a variety of causality tests with these four variables. We test for causality between the Henry Hub and NBP prices of natural gas. We also test for causality between each of the natural gas prices and the prices of WTI and Brent. Most importantly, we test for causality between Henry Hub and NBP while accounting for the potential influence of crude oil prices on those for natural gas. Taking a cue from Brown and Yucel (2008a), we also conduct the latter test while allowing for local exogenous influences that might shape the supply and demand for natural gas at Henry Hub.
2.1 The Data
Our data set allows us to examine the relationship between weekly crude oil and natural gas prices over an uninterrupted span of 570 weeks from June 13, 1997 through May 9, 2008. Although the Henry Hub, WTI and Brent prices are available for earlier dates, the uninterrupted series for the NBP price that can be considered market determined begins on June 13, 1997. We use the Henry Hub, WTI and Brent prices as reported by the Wall Street Journal and obtained as a weekly series from the Haver Analytics data base. The NBP price series is obtained from Heren and converted from pence per therm to dollars per million Btu using exchange rates reported by the Federal Reserve System.
As an initial step in our work, we check whether the data series are integrated or stationary. A time series that is integrated is said to have a stochastic trend (or unit root). Identifying a series as an integrated, non-stationary series means that any shock to the series will have permanent effects on it. Unlike a stationary series, which reverts to its mean after a shock, an integrated time series does not revert to its pre-shock level. Applying conventional econometric techniques to an integrated time series can give rise to misleading results. As shown in Table 1, augmented Dickey-Fuller tests revealed that all natural gas and oil price series are difference stationary. (1) The augmented Dickey-Fuller tests fail to reject the hypothesis that logged data have unit roots (as shown by the column labeled "Levels") and reject the hypothesis that the differenced data have unit roots (as shown by the column labeled "First Differences").
2.2 Cointegration Tests
After determining that all of the natural gas and oil price series are integrated of order 1, we test for cointegration between the two natural gas prices and between each natural gas price and each crude oil price. Two integrated series are cointegrated if they move together in the long run.
Cointegration implies a stationary, long-run relationship between the two difference-stationary series. As such, the cointegrating term provides information about the long-run relationship. If cointegration is not taken into account in estimating the relationship between the cointegrated variables, the relationship could be misspecified, and/or parameters could be inefficiently estimated. (2)
The Johansen procedure reveals that all pairs of natural gas and oil prices are cointegrated as shown in Table 2. The estimated [beta] between Henry Hub and NBP is 1.13, so that a one-percent change in NBP prices means about a one-percent change in the Henry Hub price. The estimated values of [beta] between Henry Hub and WTI and Brent are 0.44 and 0.80, respectively, which means that for a one-percent change in the price of oil, the price of natural gas changes less than one percent. For NBP, the cointegrating relationship between NBP and WTI and Brent prices are similar. For a one-percent change in either oil price, NBP changes about 0.4 percent. A trend term is not significant in any of the cointegrating relationships and is not reported.
2.3 Bivariate Estimation
Because the crude oil and natural gas price series are cointegrated, we account for cointegration in their relationship by specifying an error-correction model in which changes in the dependent variable are expressed as changes in the independent and the dependent variables, plus an error-correction term, as recommended by Engle and Granger (1987). For cointegrated variables, the error-correction term reflects the deviations from the long-run cointegrating relationship between the variables. The coefficient on the equilibrium error reflects the extent to which the dependent variable adjusts during a given period to deviations from the cointegrating relationship that occurred in the previous period.
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