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

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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.

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Energy Specializations: Energy Modeling – Energy Data, Modeling, and Policy Analysis; Energy Modeling – Forecasting and Market Analysis; Natural Gas – Policy and Regulation; Petroleum – Imports and Exports; Natural Gas – Markets and Prices; Petroleum – Markets and Prices for Crude Oil and Products

JEL Codes: Q35: Hydrocarbon Resources, Q41: Energy: Demand and Supply; Prices, Q40: Energy: General, Q38: Nonrenewable Resources and Conservation: Government Policy, L95: Gas Utilities; Pipelines; Water Utilities

Keywords: Oil, Natural gas, Peak-load pricing, Regime switching, Relative value

DOI: 10.5547/01956574.38.2.fasc

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Published in Volume 38, Number 2 of the bi-monthly journal of the IAEE's Energy Economics Education Foundation.


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