1. Dayong Zhang, Tiantian Wang and Xunpeng Shi 2017 IAEE Singapore
Understanding natural gas prices, bubbles, oil indexation and implications
Dayong Zhang, Tiantian Wang and Xunpeng Shi
2017 IAEE Singapore

2. Oil prices vs. Gas prices

3. Market segmentation
For oil, there is an international market, whereas for natural gas the markets are geographically segmented (Bachmeier and Griffin, 2006).
Natural gas is often shipped through pipelines or LNG, which limits the flexibility of trading across markets.
Long-term contracts with minimum Take-or-Pay (TOP) and the destination clauses also impose strong restrictions on LNG trading (Shi and Variam, 2016).

4. Oil indexation vs. Pricing hub
While gas prices in the US are determined based on gas-on-gas competition in hubs (hub pricing), gas (in the form of LNG) prices in Japan are mainly indexed to crude oil prices.
The European markets are in between. While UK markets have had hub pricing for more than two decades, the continental European gas market is a mix of hub pricing and oil indexation (Melling, 2010).
Oil indexation ignores fundamental factors in natural gas markets (Stern, 2014). When oil and gas are not the main substitutes in the end-user market (IGU, 2013; IEA, 2014), the price link loses its foundation.
The question is whether the hub pricing mechanism is a better choice than oil indexation.

5. Financialization and asset bubbles
Financial markets have been shown to be more influential on energy prices (Creti and Nguyen, 2015; Zhang, 2017).
Price may deviate from the fundamental value of an asset and create bubbles in the market.
Oil prices, for example Su et al. (2017), have shown multiple bubbles in recent years.
It is therefore expected to see bubbles in gas prices with oil indexation. Moreover, without proper information on the fundamental value, asset bubbles may more likely appear in the natural gas market.

6. Methodology
Phillips and Yu (2011) proposed a right tailed unit root test to identify asset bubbles.
Phillips et al (2012) proposed the sup ADF test (the generalized sup ADF extended test, GSADF) to find multiple bubbles.
The method is essentially a rolling windows version of the ADF test but with flexible window setups.

7. Data Monthly prices between May 1987 and January 2017 are used.
Gas prices are collected from the World Bank and oil prices (Brent and WTI) from EIA.
The number of total observation is 357.

8. Bubbles in US gas prices

9. Bubbles in Japan’s gas prices

10. Bubbles in European gas prices

11. Summary of bubble periodsUS EU
Japan

12. Discussions and implications
The bubble test is also applied to the oil-gas ratio and we find no bubbles in the EU, one marginal bubble in Japan and two in the US, which can be the consequence of oil indexation (Zhang and Ji, 2017).
There are more bubbles in Japan and the EU relative to the US, which is consistent with the hypothesis that hub pricing can better reflect fundamentals and thus lower the chance of asset bubble.
Compared with the EU, Japan lacks pricing hub and this has caused more bubbles to be seen in the recent years.

13. Conclusions
This paper contributes to recent debates on gas pricing mechanism and oil-gas price relationship.
We use Phillips et al. (2012) GSADF test to detect multiple bubbles in natural gas prices.
Cross regional comparison provides interesting information to understand price dynamics in the natural gas market and also evidence in favor of establishment of pricing hubs.

14. Thank you.