Empirical Investigation and Modeling of the Relationship between Gas Price and Crude Oil and Electricity Prices

Article excerpt

Crude oil and natural gas are the main sources for energy in the US and around the word. Natural gas is a relatively clean source of energy compared to oil and could be cheaper to the consumer than oil especially if there is no coupling in price between oil and gas. Therefore, it is of interest to determine the long term relationship between oil and gas prices and to develop a model for predicting gas price. In this study, we used the Johansen integration test and showed that the logarithm of crude oil prices and the logarithm of natural gas prices are co-integrated in the sense that they are in a long term equilibrium relationship in which case the two series stay together and do not diverge over time. Any divergence is usually short term and eventually the two series come back together. Also, the logarithm of electricity price was found to be cointegrated with the logarithm of natural gas price. The logarithm of the GDP was also found to be co-integrated with that of natural gas price. Using data from 1973 to 2009, a time series model was developed that related the logarithm of natural gas price to that of crude oil and electricity prices. The model is useful for predicting, in the short run, gas price from knowledge of oil and electricity prices

INTRODUCTION

The United States as well as the rest of the world are heavily dependent on oil for their energy requirement. In the US, there has been an on- going call and a recent movement on the part of the government for developing alternative, renewable, and clean energy sources. A salient argument in favor of this move is to reduce our dependence on foreign oil for our own security and economic well being and to reduce environmental pollution. A sharp increase in crude oil prices over a short time period, caused by reduced oil production due to political instability in some of the oil rich countries, could cause inflation in the US and jeopardize its security.

Developing alternative clean energy sources such as wind, bio-fuel, solar and hydro power is a long term development that should be pursued. However, an immediate source of energy that is available in abundance domestically is gas. Natural gas is believed to be an important, if not the most important, energy source for the future. Natural gas is a relatively clean source of energy compared to oil and could be cheaper to the consumer than oil especially if there is no coupling in price between oil and gas. Hence, there has been some interest in the literature in looking at the relationship of crude oil and natural gas prices. An understanding of this relationship would help in market forecasts and utilization of both commodities.

In this paper, we use time series data of crude oil and natural gas prices on a yearly basis in the US to investigate the long term relationship between them as well as between natural gas price and electricity price. In addition, we develop an empirical model relating natural gas price to crude oil price and price of electricity

RELEVANT LITERATURE

There are a number of studies in the literature investigating the relationship between natural gas price and other energy prices such as oil and electricity. Asche et al (2006) studied the long term relationship between oil, gas and electricity prices. The authors' interest was in determining if prices of any two series are co-integrated in the sense that the two series stay together and do not diverge over time. Any divergence is usually short term and eventually the two series come back together. If two series are co-integrated, then they are deemed coupled.

There was evidence from the study pointing to a co-integrated relationship between energy prices in the United Kingdom (UK) for the period, 1995-1998. Also, Pangiotidis and Rutledge (2006) found evidence for co-integration between oil and gas prices in the United Kingdom in the period 1996 to 2003. Bachmeier and Driffin (2006) presented evidence for weak co-integration between natural gas, crude oil, and coal process in the US. …