The Weak Tie Between Natural Gas and Oil Prices

The last two years has seen a dramatic decoupling of natural gas and oil prices. After prices for both commodities collapsed at year-end 2008, the price of oil recovered, but the price of natural gas has remained low. The ratio of the natural gas price to the oil price is at the lowest point in decades.

Ironically, this has happened just as a string of academic papers had firmly established that the two price series move together–for example, here, here and here. The International Energy Agency’s 2009 World Energy Outlook reprinted a table from one of these papers showing how an increase in the price of oil would be mirrored over the subsequent 12 months by a matching increase in the price of natural gas.

My colleague, David Ramberg, and I have just released a study attempting to make sense of these apparently contradictory facts. The bottom line: while a tie between the two series can be firmly established in a statistical sense, two features of this relationship have not gotten enough emphasis. First, there is an enormous amount of extra volatility in natural gas prices, so over short horizons like one or two years, the statistical tie between the two price series is very often swamped by extra swings in the natural gas price. Second, the level of the tie between the two prices — the normal ratio — is unstable over time, so that at longer horizons it is difficult to pin down the expected relationship.

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