1. The Weak Tie Between Natural Gas and Oil Prices 30 th USAEE/IAEE North American Conference October 12, 2011 David Ramberg, MIT Engineering Systems Division (Co-author and Committee Member: John E. Parsons Committee Chair: Mort D. Webster)

2. 2 Presentation to 30th USAEE/IAEE North American Conference, October 12, 2011. Do not reproduce. The Relationship Between Crude Oil and Natural Gas Prices Historically, observers have noted price relationship between crude oil and natural gas.  Rules of Thumb  10-to-1  Energy Content Equivalence (≈ 6-to-1)  Distillate Fuel Oil Burner-Tip Parity  Residual Fuel Oil Burner-Tip Parity  Cointegration (Villar and Joutz, 2006, Brown and Yücel, 2008, Hartley, Medlock, and Rosthal, 2008) Recent discussion about “decoupling”:  Temporary break from usual relationship (return later)  Permanent break from old relationship and move to new one  No longer any relationship at all Which is it?

3. 3 Presentation to 30th USAEE/IAEE North American Conference, October 12, 2011. Do not reproduce. Natural Gas and Crude Oil Spot Prices, 1991- 2010 (real 2010 dollars)

4. 4 Presentation to 30th USAEE/IAEE North American Conference, October 12, 2011. Do not reproduce. Is the Relationship Stable over Time, or has it Shifted?

5. 5 Presentation to 30th USAEE/IAEE North American Conference, October 12, 2011. Do not reproduce. Is the Relationship Stable over Time, or has it Shifted?

6. 6 Presentation to 30th USAEE/IAEE North American Conference, October 12, 2011. Do not reproduce. Methods to Test De-coupling Possibilities Revisit Cointegrating Relationship: P HH,t = γ + βP WTI,t + μ t (-0.0333 + 0.468 logP WTI,t + μ t ) P-Value of cointegrating relationship: 0.001, R 2 of full model: 0.1479 Conduct Gregory and Hansen (1996) tests using above functional form and iteratively test for breakpoints at each observation. Apply VECM/Conditional ECM methodology from June 1997 to identified breakpoint March 2006: logP HH,t = -1.2007 + 0.7261 logP WTI,t + μ t  P-Value of cointegrating relationship: 0.0000, R 2 of full model: 0.2094 Apply VECM/Conditional ECM methodology from March 2006 to identified breakpoint February 2009: logP HH,t = 0.1969 + 0.4621 logP WTI,t + μ t  P-Value of cointegrating relationship: 0.0000, R 2 of full model: 0.2603  No cointegrating relationship identified between February 2009 and December 2010

7. 7 Presentation to 30th USAEE/IAEE North American Conference, October 12, 2011. Do not reproduce. Graphing Two Cointegrated Periods Against Actual Henry Hub Prices

8. 8 Presentation to 30th USAEE/IAEE North American Conference, October 12, 2011. Do not reproduce. Conclusions  Crude oil and natural gas prices in the U.S. tend to be cointegrated in the long-run, but:  Volatility in natural gas prices much higher than crude oil prices. Frequent deviations from long-run relationship  Relationships gradually shifting as new technologies and policies that govern interaction between fuels, demographic, and other demand-side factors develop  Models themselves only generally accurate at relating natural gas price levels vis-à-vis crude oil prices.  Post-February 2009 period likely indicative of relationship in flux rather than permanent severance of crude oil-natural gas pricing relationship.  Due to shortage of data points to uncover a subtle relationship/lack of much price variation, and  Likely because of advent of economic methods for shale gas extraction coming online.  New equilibrium will likely develop over time.

9. The End Questions?

10. Additional Slides

11. 11 Presentation to 30th USAEE/IAEE North American Conference, October 12, 2011. Do not reproduce. The Mathematics Behind VECM and Conditional ECM Cointegration Models Vector Error Correction Model (VECM): Conditional Error Correction Model (conditional ECM):

12. 12 Presentation to 30th USAEE/IAEE North American Conference, October 12, 2011. Do not reproduce. Methods to Test De-coupling Possibilities Test for a co-integrating relationship:  Search for a combination of the two variables of a specified functional form that is stationary over time.  After accounting for short-run divergence from this long-term relationship and subsequent readjustment back to the long-term relationship, the remaining errors are stationary.  Persistent result is that US natural gas & oil prices have been cointegrated. Data on seasonal, weather, and supply-related variables unavailable before June 1997 Basic cointegrating relationship from June 1997 – December 2010:  logP HH,t = γ + β logP WTI,t + μ t  = -0.0333 + 0.468 logP WTI,t + μ t Cointegrating relationship has smaller in-sample errors than any of the rules of thumb

13. 13 Presentation to 30th USAEE/IAEE North American Conference, October 12, 2011. Do not reproduce. Graphing Two Cointegrated Periods Against Actual Henry Hub Prices