Modeling UK Natural Gas Prices when Gas Prices Periodically Decouple from the Oil Price

When natural gas prices are subject to periodic decoupling from oil prices, for instance due to peak-load pricing, conventional linear models of price dynamics such as the Vector Error Correction Model (VECM) can lead to erroneous inferences about the nature of cointegration relationships, price adj...

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Bibliographic Details
Published in:The Energy journal (Cambridge, Mass.) Mass.), 2017-03, Vol.38 (2), p.131-148
Main Authors: Asche, Frank, Oglend, Atle, Osmundsen, Petter
Format: Article
Language:English
Subjects:
Decoupling
Economic models
Error correction
Gasoline prices
Loads (forces)
Natural gas
Natural gas industry
Natural gas prices
Oil
Peak load
Petroleum
Price increases
Prices and rates
Pricing
Switching
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Summary:When natural gas prices are subject to periodic decoupling from oil prices, for instance due to peak-load pricing, conventional linear models of price dynamics such as the Vector Error Correction Model (VECM) can lead to erroneous inferences about the nature of cointegration relationships, price adjustments and relative values. We propose the use of regime-switching models to address these issues. Our regime switching model uses price data to infer whether pricing is oil-driven (integrated) or gas-specific (decoupled). We find that UK natural gas (NBP) and oil (Brent) are cointegrated for the majority of the sample considered (1997-2014). UK gas prices tend to decouple during fall and early winter, when they increase relative to oil consistent with seasonal demand for natural gas creating gas-specific pricing. When evidence favors integrated markets, we find that the industry 10-1 rule-of-thumb holds (the value of one MMbtu of natural gas in the UK market is one tenth the value of one barrel of Brent oil), while the overall relationship, including decoupling periods, is 9.2-1. The paper highlights that what relative value to use, depends on the purpose of its use.
ISSN:0195-6574
1944-9089
DOI:10.5547/01956574.38.2.fasc