Convergence and Divergence of Crude Oil and Natural Gas Prices

This research investigates the possibility that WTI crude oil and Henry Hub natural gas prices share a stable link. Economic theory suggests that the two commodities are linked by both supply and demand given that the commodities can be coproduced and many consumers have the ability to switch between the fuels. In general, it would appear that the two commodities support this theory with natural gas prices tracking crude oil prices fairly well until late 2008. However, since the end of 2008 the two price series have diverged and appear to move independently of each other. Reduced fuel switching capabilities in U.S. industry and electric power generation coupled with increased technology and production from shale formations have potentially changed the driving force behind natural gas prices. However, a severe recession has impacted world economies over the same time period making the cause of the disparity between crude oil and natural gas prices unclear. Therefore, this research analyzed the possible long-term link between the two commodities over two timeframes. Using an error correction model that includes exogenous factors affecting the short-run dynamics of natural gas prices over the period January 1999 through September 2008, I find evidence of a long-run cointegrating relationship between natural gas and crude oil prices. Additionally, crude oil prices are found to be weakly exogenous to the system, suggesting causality runs from crude oil to natural gas prices. Extending this series through February 2012 yields much weaker evidence of a cointegrating relationship and provides evidence for the decoupling crude oil and natural gas prices.