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Weekly Updates1. INTRODUCTION
Markets for natural gas have witnessed profound changes in the past decade. Liberalization in most parts of the world, restructuring of former vertically integrated supply chains, and falling transportation costs especially for liquefied natural gas (LNG) have pushed the emergence of a new "international natural gas market", replacing the former regionally segmented markets in North America, Europe, and Asia. In addition, traditional pricing schemes are being reviewed moving from long-term, often oil-price indexed natural gas prices towards prices based on market mechanisms.
The literature on market integration in commodity and natural gas market has studied a variety of regional integration processes, but global natural gas markets per se have not yet been analyzed. The integration of the North American market following FERC Order 436 (1985) has been studied extensively, e.g. by Serletis (1997), Walls (1994), and De Vany and Walls (1995), who use correlation and cointegration analysis. Results of an integrated market were confirmed by studies using other econometric tools such as time-varying coefficients, Johansen test procedure, and impulse response functions, e.g. King and Cuc (1996), Cuddington and Wang (2006), and Serletis and Rangle-Ruiz (2004). Work on the cointegration of European natural gas import prices was first carried out by Asche, Osmundsen and Tveteras (2001, 2002). For the UK market, that has been liberalized 15 years earlier than Continental Europe, Panagiotidis and Rutledge (2007) show that the linkage between the natural gas price and the price of oil has become more volatile over time which can be interpreted as a sign of decoupling of the natural gas price from the oil price. Neumann et al. (2006) have shown that integration between the UK market and the largest Continental European wholesale market (Zeebrugge) works well, but that price convergence between different Continental European markets is still to come about. Last but not least, Siliverstovs et al. (2005) were the first to address the issue of international market integration for natural gas; they concluded that for the period preceding liberalization of natural gas markets in Europe, i.e. the 1990s, the hypothesis of integrated transatlantic natural gas prices should be rejected.
The EMF 23 study has a focus on prices and trade patterns in international natural gas markets presenting regional prices for natural gas. These are mainly calibrated by linking natural gas to petroleum prices (EMF, 2007, p. 18). However, price dynamics in natural gas markets may differ from those of crude oil, e.g. due to a different industrial organization of the sector. Existing literature analyzes the relation of different commodities (Hartley et al., 2008, Brown and Yucel, 2008, Villar and Joutz, 2006) and argues in favor of a long-run stable relationship of crude oil and natural gas prices. This paper provides evidence on the integration of international natural gas markets, hence spot prices for a single commodity. We test the theoretical proposition that in integrating markets of homogenous products, prices should move in the same direction; when achieving full integration, price differentials should only represent differences in transportation costs and/or quality. Construction of LNG import and export facilities worldwide facilitates flexibility in global trade of natural gas. Our hypothesis, spurred by evidence and market participants, is that as markets, in particular transatlantic natural gas markets, are getting closer intertwined, price integration is the natural consequence.
The remainder of the paper is structured in the following way: the next section describes the recent developments on the international natural gas markets upon which our hypothesis of increasing integration is based. Section 3 provides the model specification and explains the data on natural gas and oil prices. Section 4 presents the estimation results: we find a trend towards a higher level of integration between North American and European natural gas prices. Section 5 concludes.
2. RECENT TRENDS IN INTERNATIONAL NATURAL GAS MARKETS
International natural gas markets have gone through substantial institutional and economic changes during the past decade. This section describes the major changes on the North American and the European wholesale markets, and points out the critical role of liquefied natural gas (LNG) for the process of integration.
2.1 Development of Trading Hubs in North America and in Europe
North America pioneered the restructuring of natural gas markets as early as the 1970s, with deregulation of wellhead prices (Natural Gas Policy Act, 1978) followed by opening up of access to the trunk line natural gas infrastructure (FERC Order 436, 1985). Subsequently, the trading place "Henry Hub" in Louisiana emerged as the market centre. It is closely connected to not less than 16 pipelines, LNG infrastructure and three salt caverns for storage. Since 1988 Henry Hub serves as delivery and reference point for the New York Mercantile Exchange (NYMEX) gas futures contract and is the reference point for all natural gas export contracts to Mexico. Natural gas futures at the NYMEX have a depth of 5 to 6 years and are complemented by options since 1992. It is a liquid market serving as reference for almost all natural gas trade in North America.
The UK followed the US path with a time lag of about a decade. Breaking up the monopoly of British Gas in the UK in 1986 marked the landfall of the first truly competitive gas market in Europe. Already in 1994 the National Balancing Point (NBP), a notional trading point on the National Transport System (NTS), was used as an informal market and developed towards the main place for spot natural gas trading activities from 1996 onwards. There has been a steady increase in volume traded both physically and financially. A further expansion is expected once the LNG import quantities rise to substantial levels after the opening of import terminals (Isle of Grain, Milford Heaven). Recently, the NBP has served as a reference point for prices in long-term contracts, which has furthermore strengthened its role.
Continental Europe trailed far behind the US and the UK for a long time, until the EU Acceleration Directive (2003/55/EC) paved the way to a more stringent market opening. With regard to wholesale markets, the only significant development to date was the opening of the Zeebrugge hub (Belgium), after the connection with the UK through the Interconnector pipeline. Since its start in 1999, traded volumes have increased steadily. A second hub on the Dutch transmission grid (TTF) was set up in 2003 and has gained more importance since 2005. We seem to observe a certain "deja vu" effect of repeated history of natural gas trading in Continental Europe, now in its early stages as was Henry Hub 20 years ago.
The restructured industry in Europe and North America features a high proportion of spot trading. Recent natural gas sales contracts are of a relative short duration comparatively to the traditional long-term contract. Contract prices are being keyed to a natural gas market indicator, since oil-linked pricing is a poor indicator of a gas-to-gas competitive market. Trade press reporting for a reference point such as the Henry Hub in America, the NBP in the UK, or Zeebrugge in Continental Europe provides transparent information about the market. This favors competition, an aspect to which we now turn.
2.2 Increasing Role of LNG and Emerging Transatlantic Competition
Given its ease of use and environmental friendliness, natural gas has become a key fossil fuel for the power sector and other industrial and residential demand. Demand for natural gas is increasing in all regions of the world, thus leading to upward pressure on prices and potential competition between the formerly segmented regions. In this context, the increase in LNG-trade provides the missing link for market integration across regions, in particular across the Atlantic Ocean. Although LNG has been around for about four decades now, it is only during the last decade that it has come to play a role as a serious means of interconnecting markets. In fact, one already observes an active arbitrage in the Atlantic Basin, where LNG shipments from Trinidad and Nigeria have been diverted either to the US or Europe depending on spot prices. The impact of these swaps and diverting activities has so far only been modest on the spot price in countries where cargoes have been sent to.
The three major natural gas consuming regions of the world (North America, Europe, and Asia) differ in their import structure. Whereas LNG so far has only played a minor role in North America representing 3.6 % of US natural gas consumption in 2007, countries like Japan and South Korea are fully dependent on LNG imports. In Europe both pipeline and LNG imports coexist and quantities differ on national levels. However, construction of a number of LNG importing facilities in the US and Europe should lead to significant interaction of these two regions.
According to theory, arbitraging possibilities occur in cases when the price differential of a homogeneous commodity exceeds transportation costs. Thus, convergence of North American and European prices should take place until the difference reflects only transportation costs. The technical prerequisites for LNG to play that role are fulfilled: there is an increasing amount of liquefaction and regasification capacities on either side of the Atlantic. Ship capacities are not critical, first, because there is a large amount of non-dedicated capacities under construction (IEA, 2007, p. 52), and second, there are no observable barriers to entry into that market. A favorable regulatory regime is established following the Hackberry Decision in the US and Article 22 of the European Gas Directive 2003/55/EC.
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