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Research: The Fundamental Relationship between Natural Gas and Crude Oil Prices in North America

This multi-faceted study investigates the relationship between petroleum product prices and natural gas prices in North America. The effort has been undertaken with sponsorship from and collaboration with McKinsey & Company.  A principal goal of the study is to better inform policy makers and industry participants of the interrelationship between crude oil and natural gas pricing in North America.

The nature of the relationship between natural gas and crude oil prices is critical to understanding the outlook for the future.  For example, it will become increasingly important to understand how geopolitical influences in the world oil market might permeate through North American natural gas markets, especially as regional gas markets become increasingly connected through LNG trade.  This will have ramifications for the investment decisions of private firms as well as the direction for U.S. national energy policy. Understanding the links and influences of global crude oil markets on the U.S. natural gas supply and pricing situation is an important building block to creating an adequate U.S. strategic energy policy for the North American natural gas and power generation sectors.

Recently, volatility in the oil-gas price ratio has led some to question whether or not a stable long run relationship between crude oil prices and natural gas prices exists.  We demonstrate in this study that a long run relationship does exist.  However, it is important to account for electricity generating technologies in the long run as fuels compete on a cost basis in electricity generation.  It is also important to control for various short run factors such as weather trends and natural gas and petroleum product storage to understand why natural gas and petroleum prices sometimes diverge from their long run equilibrium.

The first paper of the study, “An Econometric Evaluation of the Demand for Natural Gas in the Power Generation and Industrial Sectors,” investigates the demand-side influences on the long run relationship between crude oil and natural gas prices. Theory suggests that fuel substitution capabilities within the electricity sector, at either the plant level or grid level, should contribute to the co-movement of natural gas and petroleum product prices. In addition, substitutability between natural gas and petroleum products in the industrial sector, through both direct use and the cogeneration of electricity, can also influence the fuel price relationship.

The second paper in the study, “The Long Run Relationship between Crude Oil and Natural Gas Prices,” investigates the long run equilibrium between the U.S. prices of natural gas and petroleum products, and the short run forces that can drive disequilibria.  We use time series techniques to show that there exists a stable long run relationship between U.S. natural gas prices and petroleum product prices once technology is taken into consideration.  Moreover, if there is a short run departure from the long run equilibrium, forces will act to bring prices back into their long run equilibrium.

The third paper, “A Brief Narrative on the International Influences on the Link between U.S. Crude Oil and Natural Gas Prices,” expands the study scope to address international influences on the oil-gas pricing relationship that could grow increasingly important as natural gas becomes a more global commodity.  Specifically, we ask whether the relationship between crude oil and natural gas prices found in the United States holds for other regions, such as Japan and the European Union.  Moreover, as natural gas is increasingly traded internationally, this paper posits whether market realities in other regions might cause the existing price relationship between crude oil and natural gas in the United States to shift over time. The likely roles of long term contracts, financial markets, supply-side considerations, and geopolitics are all addressed.  A key point of the narrative is that none of the factors that influence the relationship between crude oil and natural gas is independent of the others, and they can serve to reinforce or offset each other.  Thus, while it is important to think of these factors independently to understand their influence, it must be recognized that they act in concert to determine market adjustments at the aggregate level.

Click here see the study Policy Report, Working Papers and Event Presentations.


This study was generously cosponsored by the Baker Institute Energy Forum Sponsors and McKinsey & Company.