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MIT Study of Relationship Between Oil and Gas Prices

One of the remarkable aspects of the oil and gas markets over the last few years has been the rapid decline of natural gas prices despite the continuing high price of crude oil. Historically, analysists have assumed that there is a relationship between the price of the two commodities. After all, both are basically sources of stored energy, which can be measured in British Thermal Units, or Btus.  One barrel of crude oil has about the same energy as six million Btu of natural gas, so it has been assumed that one barrel of crude should have about the same value as six MMBtu of gas.  When companies report their reserves, they often use the term BOE, or “barrels of oil equivalent,” meaning that they convert their gas reserves to oil barrels using this 6-to-1 ratio.  But at today’s prices, the ratio on a Btu basis is closer to 12-to-1; it has been as low as 2.5-to-1 and as high as 19-to-1. So why is there now such a de-coupling of oil and gas prices? 

I recently ran across a paper published by two MIT professors titled “The Weak Tie Between Natural Gas and Oil Prices,” by David J. Ramberg and John E. Parsons. You can find it here. The authors ask the question: Is there a relationship between the price of oil and the price of natural gas? If there was formerly such a relationship, has it been broken? They use historical data and analysis to answer these questions. Their conclusion:

despite large temporary deviations, natural gas prices continue to exhibit evidence of a cointegrating relationship with crude oil prices, and gas prices consistently return to a long-run relationship. However, this relationship has apparently shifted at least once over a 12-year period to a new equilibrium. There is no statistical evidence to support the claim that a relationship between the two price series has been completely severed.

However, the authors also point out that “there is an enormous amount of unexplained volatility in natural gas prices. The raw price serices for natural gas … is approximately twice as volatile as the raw oil price series. And the relationship between oil and gas prices “does not appear to be stable through time. … In the 1989 to 2005 period, the price of natural gas seemed to be shifting up compared to the price of oil, but in recent years this reversed.”

The authors analyze the effect on natural gas prices of seasonality — heat and cold waves and supply disruptions from hurricanes — and the relationship between gas prices and the amount of natural gas in storage. After taking these effects into account, there is still a large unexplained volatility in natural gas prices.

Nevertheless, the authors say that their analysis shows that “when the natural gas price has been pulled away from the fundamental tie, it will predictably drift back towards it.” Producers with large natural gas reserves are hoping the authors are correct.

 

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