# Presentation: 223370

## An Empirical Evaluation of Relationship Between Crude Oil and Natural Gas Prices

**Meeting with the the American Statistical Association Committee on Energy Statistics **
**With the **
**Energy Information Administration**
**April 7, 2006**
**Jose Villar **
**jvillar@eia.doe.gov**
**Natural Gas Division**
**Energy Information Administration (EIA)**

## Natural Gas and Crude Oil Prices Have Appeared to Decouple at Times

## Discussion Goals

**Get input on the econometric modeling. **
**What are the implications of the VECM for the NEMS?**
**How can EIA best use what has been learned from the study?**
**Are there things we haven’t considered? **

## Objectives of the Analysis of Crude Oil and Natural Gas Prices

**Identify the economic factors linking crude oil and natural gas markets **
**Statistically test for the possibility of a long-run relationship between natural gas and crude oil prices**

## Demand Factors Linking Crude Oil and Natural Gas Markets

**Natural gas and petroleum products are substitutes in consumption. An increase in the price of crude oil will increase the demand for natural gas, increasing its price. **
**Competition between natural gas and petroleum products occurs principally in the industrial and electric generation sectors.**

## Supply Factors Linking Crude Oil and Natural Gas Markets

**Increases in crude oil prices may increase natural gas produced as a co-product of oil, tending to decrease natural gas prices.**
**Increased crude oil prices may spur more exploration and development as cash flow expands, which could put downward pressure on natural gas prices.**
**An increase in crude oil prices may lead to increased costs of natural gas production as natural gas and crude oil operators compete for similar economic resources.**

## Natural Gas and Crude Oil Prices Appear to Follow Similar Trends

**Logarithms of Natural Gas and Crude Oil Prices **

**Crude Oil Prices Mean-Shifted and Rescaled **

## Cointegration Analysis of Natural Gas and Crude Oil Prices

**Two variables are cointegrated if**
**They are unit root processes **
**A stationary linear combination of them can be found**
**If the price of natural gas, p****g**** , and the price of crude oil, p****o****  are cointegrated, then**

## The Cointegrating Relation Depicts the Deviation of the Price of Natural Gas from the Price of Crude Oil

## “Equilibrium” Correction Mechanism

**The cointegration relation is interpreted as a long-run relation or an “equilibrium” correction mechanism for modeling purposes.**

## The Vector Equilibrium Correction Model and Cointegration

**The Vector Equilibrium Model (VECM) uses the cointegration relation to help explain short-run movements in natural gas prices.**
**The VECM expresses changes in prices as a function of short-run and long-run effects, as well as the speed of adjustment from disruptions to the long-run equilibrium.**
**Δ**** P****g,****t**** ****= ****0.3****Δ****P****o,****t**** + ****0.10****Δ****P****g,****t-1**** - **** .2**** ECM****t-1**** + v****t**

**Short-run effect**

**Long-run equilibrium**

## The Estimated VECM Provides a Good Fit of Natural Gas Prices (1989-2005)

**Fitted Model and Actual Values **

**Scaled Residuals of Fitted Model**

## Estimates of the Equilibrium Correction Model Are Stable Over the Period of Analysis

**Recursively Estimated Crude Oil Price Parameter**

**Recursively Estimated Deterministic  Trend Parameter**

## Implications of the VECM for the Analysis of Crude Oil and Natural Gas Prices

**Crude oil and natural gas prices have a stable long-run relationship.**
**Crude oil prices influence but are not influenced by natural gas prices.**
**Natural gas prices have been growing at a slightly faster rate than crude oil prices. **
**About 20 percent of a disruption from the long-run equilibrium will be recovered in the following period.**** **

## Implications of the VECM:Model Dynamics

## Where Should EIA Go From Here?

**What is the best choice with respect to data frequency—monthly or weekly?**
**The use of Impulse dummy variables to capture/suppress the effects of outliers**
**What are the implications of the VECM for the NEMS?**
**How can EIA best use what has been learned?**
**Are there other things that we have not considered? **

## www.eia.doe.gov

**www.eia.doe.gov**

**Notes:**
Add your questions to the Committee here for the discussion that is to follow your presentation

ALSO:  insert/add a slide (2nd space maybe) that tells the Committee what you want them to discuss, i.e., what are your questions that they should be thinking about during your presentation.